The Cold Facts About The Aussie Dollar

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By Greg Peel

The new rule of thumb is that if oil reaches US$150/bbl, the Aussie dollar will hit parity with the US dollar. If global oil demand can be used as a proxy for overall commodity demand, then the argument goes that Australia, as a major commodity exporter, will greatly benefit from higher commodity prices as reflected in its terms of trade. A strong terms of trade means a strong economy, and a strong economy is reflected in a strong currency.

Oil is scaring the bejesus out of everyone (bar oil producers) at present as it clips US$135/bbl (well, at least until yesterday), but it is easy to forget that we have recently seen exponential jumps in other commodities as well. The annual iron ore contract price could adjust up by as much as 100%. The annual coal price has already adjusted by 200%. Gold has been to US$1000/oz. Copper has recently tested US$4.00/lb once more. Fertiliser prices are 200% higher than they were a year ago. Even the beleaguered farmers are looking good on grain prices.

If you wanted a simple argument for why the Aussie is as high as it is right now – it’s commodity prices.

Of course, the AUD/USD price is not a price, but a ratio. Thus the Aussie’s rise is as much a part of weakness in the US currency as it is in strength of its own. So often when explaining away strength in the Aussie an economist will cite weakness in the US dollar as well as strength in commodity prices.

Another common excuse for Aussie strength is the tightening cycle in Australian interest rates. With inflation proving a difficult beast to tame in Australia the Reserve Bank has not only increased the cash rate aggressively in past months, it has signalled it may go again. A higher cash rate implies higher bond rates, and offshore investors are thus attracted to high-yielding Aussie bonds, and purchasing them increases demand for the Aussie dollar.

Which brings us to the infamous yen carry trade. With the Japanese cash rate at 0.5% the financial world has been borrowing in yen and madly investing in anything and everything that carries a significantly higher yield, such as Aussie bonds. The credit crunch sent this trade wobbling, given an adverse movement in relevant currencies can quickly turn a profit into a loss. This is why the yen is used as a global risk appetite barometer. And as the Aussie cash rate has climbed to 7.25% at a time when the financial turmoil of past months has begun to ease, the yen carry trade has also helped to push up the Aussie.

So to summarise, economists will tell you the Aussie dollar has hit 25-year highs on a combination of a weaker US dollar, strong commodity prices, a higher Aussie cash rate and the yen carry trade.

Rubbish.

Well – it’s not actually rubbish, but let’ just say all roads lead to Rome.

Every economics student learning about how global foreign exchange works first learns about a thing called “covered interest arbitrage”. In typically academic “perfect world” form, covered interest arbitrage means that if one country’s interest rate is low, and another high, there should be no profit to be made in borrowing in the low rate currency and investing in the high rate currency because the exchange rate will immediately adjust to wipe out that disparity. This is because one must buy the high-yielding currency first in order to benefit from the higher interest rate, and then bring profits back into the lower-yielding currency to achieve the benefit. The ratio implied by the exchange rate should ensure the end result is zero. Otherwise you’d do it all day till the cows came home.

Ah hah! But isn’t that exactly what yen carry traders are doing? Making a profit on interest rate disparity?

That is correct. And it just goes to reinforce the fact that there is never a perfect world. However, yen carry traders are not “arbitraging” the disparity because they still carry a currency risk. That’s why whenever the financial world gets jumpy about risk, carry traders bail out very quickly in fear the currency ratios will rapidly adjust. By doing so, they actually make the currencies adjust anyway. That’s why the yen shot up as the credit crunch hit, and shot up even more violently the day LTCM went under in 1998. In 1998, short term carry traders lost a fortune. They were beaten by the rules of covered interest arbitrage.

One year ago, the Aussie dollar was trading around US$0.83. The RBA’s cash rate was 6.5%. Then the credit crunch hit. As yen carry traders headed for the sidelines the Aussie dropped rapidly to US$0.77. However the Fed shortly began its round of aggressive interest rate cuts and the Aussie headed north once more. There’s been a few wobbles in between, but now that the RBA cash rate has been raised to 7.25% with a threat to go higher, the Aussie has hit US$0.96. Clearly carry trading has played a big part. Here is a one year chart of the AUD/USD:

If the Aussie was at only US$0.83 a year go, and is now at US$0.96, the implication should be that yen carry trading is even stronger now than it was a year ago. But here is a chart of the AUD/JPY:

Undoubtedly the trend over the last couple of months has been an Aussie surging against the yen, reflecting yen selling and Aussie buying. But look where we are compared to one year ago – square. Yet the AUD/USD is US13c higher.

Ah yes, you say, but we’re forgetting commodities. The rising price of commodities have driven the Aussie higher.

Okay. But Japan is one of Australia’s biggest trading partners. Resource-poor Japan is a major buyer of Australian coal and iron ore. So if the Aussie’s movement were to reflect higher commodity prices specifically, one would presume the Aussie-yen would have risen substantially over the last year. Yet it hasn’t.

Europe is also a major commodity importer, feeding its extensively industrialised economy. So by the same argument you would expect the strength of commodity-rich Australia to be reflected in the exchange rate against commodity-poor Europe. But if we look at the chart…

…we note that the AUD/EUR is also exactly where it was a year ago. The “high commodity price” argument appears to have broken down.

It hasn’t actually broken down at all. The simple truth is that global commodities are priced in US dollars. The reason commodity prices are much higher is because the US dollar is much lower.

But that’s not true! What about Chinese demand!

Chinese (and other developing economy) demand is obviously the most dominant factor in commodity price increases this year. However, this is once again where the “perfect world” scenario does not exist. China’s currency is artificially pegged to the US dollar. Were it allowed to float it would revalue by some 40%. This would not only wipe out Chinese manufacturing margins, it would cause the entire Chinese economic engine to collapse.

The US economy has brought itself to the brink because of the subprime crisis. But prior to those ramifications the US dollar was already weak due to its massive current account deficits against Japan and Germany and an ever-ballooning deficit against China. While this is due to America spending beyond its means, it is also true that had China’s currency been allowed to float all along, the US dollar would not have been nearly as weak as it is. The US would never have been able to afford to gobble up Chinese manufactured goods, nor outsource its manufacturing base to China. Thus the Chinese economy would not have been running at 12% growth.

In which case there would not be the same demand for commodities out of China. So China’s growth has relied upon its peg to the US dollar, even though that peg was forcing the US dollar lower because of the building deficit. Throw in the subprime crisis, and the US dollar has collapsed. China is forced to buy commodities from, for example, Australia. The prices China has to pay are that much higher because the US dollar is that much lower. Australian producers then sell those US dollars received and buy Aussie dollars. Result – a higher Aussie.

Why did the US dollar collapse? Well generally because the US economy has gone into recession and the Fed has been forced to print billions in fresh liquidity to save the financial markets. This is represented by the cut in the Fed cash rate from 5.25% a year ago to 2% now.

In the meantime, higher commodity prices, driven by a lower US dollar, have fuelled spiralling inflation around the globe. Australia is no exception, and thus the RBA has been forced to raise its cash rate from 6.5% to 7.25%. Why is the Aussie now at US$0.96? Because the interest rate differential between the two economies has blown out from 1.25% to 5.25%.

Covered interest arbitrage.

As I suggested, all roads lead to Rome. Exchange rates do not lie. Everything can be traced back to currency movements and, quite simply, a weak US dollar. If oil does go to US$150/bbl it will not do so without a counteractive fall in the US dollar, which will be put down to the high oil price sending the US economy deeper into recession. It’s all chicken and egg stuff, but then that’s all economies are.

It is an exciting prospect for the Aussie dollar to go to parity with the US. If it does it means that commodity demand remains strong. However, what we are only now beginning to see is a catch-up in average Aussie dollar forecasts from both corporations and analysts.

It is not prudent for analysts to be constantly marking the Aussie to market in stock valuations because you’d just end up with stock valuations that are all over the shop. Hence analysts only ever adjust their currency forecasts periodically, just as they do their commodity price assumptions. Ever since the super-cycle began analysts have been slow to adjust their commodity price forecasts to reality. Now they are a lot quicker, having been caught out too often in the last four years.

It remains to be seen, however, whether they will be a lot quicker this time to adjust their Aussie forecasts. This time last year the Aussie was at US$0.83 but analysts were still working off currency assumptions in the seventies. Corporations were even more behind the times, as they often only change their currency forecasts once a year. Once upon at time the Aussie dollar was not nearly as volatile as it is today.

Take the example of Iluka, just to name but one. When the Aussie was at $0.83 Iluka was using a forecast for profit guidance of US$0.75. Analysts were using guidance as  benchmark. Then suddenly Iluka came out with a profit downgrade that shocked the market. The reason for the downgrade was that revenues had been severely impacted by the higher Aussie – an Aussie that was much higher than Iluka’s US$0.75 assumption. For some strange reason, analysts never saw this coming. They rushed to downgrade their own Iluka forecasts and recommendations, blaming that uncooperative Aussie as they went.

Therein began a stream of downgrades across all exporters and corporations with significant revenue sourced in the US. Company guidance and analyst valuations had been overstated all along, for the simple reason that they hadn’t kept pace with a raging Aussie dollar.

The Aussie dollar is now raging once more. While commodity prices may continue to go higher, the bottom line profits will be offset by a rising Aussie. It is incumbent upon corporations and analysts to take this into account before any more downgrade bombshells are dropped.

This morning Merrill Lynch put out a report on Iluka in which it was noted the company is assuming an exchange rate of US$0.90. As this now seems potentially wishful, the Merrills analysts have themselves assumed US$0.94, and thus have a revenue expectation below guidance. Merrills has learnt from experience. The Aussie is presently toying with US$0.96, and might go to parity.

If the Aussie is heading to parity, be ready for the downgrades.

Analysts at Credit Suisse published a report on the possibility of the Aussie reaching parity with the greenback in the year ahead. They believe this is a genuine possibility.

Credit Suisse has used today’s report to warn investors that if the Aussie were to reach parity with the US dollar, this would ”detrimentally affect companies with large currency translation requirements”. Think James Hardie ((JHX)), for instance, and News Corp ((NWS)) but also companies such as CSL ((CSL)) and Cochlear ((COH)).

Also, Credit Suisse points out, there are others who will be facing ”intense import competition pressures” as a result of the stronger Aussie dollar. Companies such as PaperlinX ((PPX)) and Gunss ((GNS)).

On the other hand, some companies will actually gain from this and main candidates are those with costs largely denominated in US dollars, but revenues largely in Australian dollars. Credit Suisse mentions JB Hi-Fi ((JBH)), Pacific Brands ((PBG)) and GUD Holdings ((GUD)).

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