Australia | Sep 22 2010
By Greg Peel
Since the GFC, the Australian dollar has largely settled into the role of the global “risk trade” currency. In simple terms, if the world (and particularly US hedge funds) are panicked about the global economy, it retreats into the sanctuary of the reserve currency via US Treasury bonds or simply cash. But if it is feeling confident about the global economy, it invests in stocks and commodities and the high risk/high reward space of emerging markets.
But emerging markets are volatile, have immature financial and banking systems and are subject to dictatorial government intervention. Australia does not suffer from these conditions, and as a commodity exporter the performance of the Australian economy is derivative of the performance of emerging market economies for a large part. Thus investment in Australia is a safe proxy for investment in emerging market performance.
When commodity prices rise, the Aussie dollar rises, given the expected flow-through to Australian economic performance. Investors can choose Aussie bonds in anticipation that a stronger economy will lead to higher yields, or can choose investment in Australian resource sector and other stocks. In either case the purchase of such by foreigners means buying Aussie dollars. And if bond and stock prices rise and the Aussie rises, offshore investors win twice.
That's one reason the Aussie has witnessed a step-jump in volatility post-GFC and compared to the more sombre nineties. Now that China's economy appears not to be slowing as much as previously feared, and the US Federal Reserve is threatening further quantitative easing to beat deflation (which is negative for the US dollar), the Aussie has waved goodbye to US95 cents and has parity in its sights. While much anticipation is already built into that price, the more recent hawkishness of the RBA – being its suggestion that whether or not the economy is being driven mostly by Western Australia and not by the eastern states, the RBA will have to raise rates anyway to avoid an inflation blow-out – is fuel to expectations parity may not be far off.
The fact that the Aussie dollar has become the world's risk currency has been evident in the recent very strong correlation between movements in commodity prices, stock indices and the currency. Basically, they all go up in lock-step. However, as Macquarie economists note, a recent development has actually seen the Aussie shift away and outpace both commodity and stock price movements.
That development was the June “revaluation” of the Chinese renminbi. It was not a revaluation in the traditional sense, but a revaluation was effected when the PBoC announced the application of a more flexible renminbi valuation mechanism. Whereas the renminbi has long been subject to a controlled peg to the US dollar through a limited trading range, in June this shifted to a range in relation to an unnamed basket of currencies. This affected added weakness to the US dollar which did not show up in the movement of the US dollar index (the renminbi is not included) but has been manifested in the outperformance of the Aussie.
So the first question is: is parity a good or bad thing? The second question is: would the RBA seek to intervene if the latter is the case?
The first point to note is that parity, being an AUD/USD rate of US$1.00, is just a number like any other and of no significance other than psychologically. It does, of course, make it easier to calculate back the ticket prices at Disneyland if you're an Aussie tourist, but that's not important right now. Given the Aussie hasn't seen parity since 1982 however, it's not a number we're all too familiar with.
In simple terms, a stronger Aussie reduces the value of exports to local producers and reduces the cost of imports to local retailers, all things being equal. The “all things being equal” part is important because Australia's commodity exporters stand to be hit on the earnings line by the stronger currency unless the USD price attained for those commodities also rises in concert. It also assumes consistent volumes of export and one must note importers of commodities will turn to “cheaper” suppliers if able. (But when it comes to iron ore and coal for example, the choices for importers are limited.)
So in a perfect world whatever is lost by the export side of the equation is gained by the import side of the equation, given importers of televisions, for example, can either pocket the cheaper wholesale cost of goods or pass it on to customers in expectation of stronger volumes of sales. Currently Australia's balance of trade has seen a big blow-out to the surplus side due to relentless commodity sales on one side and a timid consumer on the other. A stronger Aussie serves to bring the trade balance back into line.
But Australia's economy is not evenly balanced, and indeed it is presently very heavily weighted toward commodity exports. This implies a stronger Aussie should have a dampening effect on the Australian economy. And that throws up an interesting quandary.
The world currently believes the RBA will again start raising interest rates, if not in October then at least in November. A lot of the Aussie's strength can be put down to that simple anticipation. But were the RBA to raise rates again it would be in response to above-trend economic growth and subsequent inflation pressures driven by said exports. The Aussie acts as a dampener on economic growth and thus inflation. In other words, the RBA needs to take the Aussie level into consideration when deciding upon monetary policy.
Might the RBA hold off on that basis?
The RBA's modelling, notes Macquarie, suggests a 10% rise in the AUD reduces GDP growth by 0.5% and inflation by 0.6%. On the other hand, a 1.0% rise in the cash rate reduces GDP growth by 1.0% and inflation by only 0.4%. The Aussie has risen 13% in three months while the RBA has held the cash rate steady.
Macquarie has selected the RBA's last round of forecasts in August as a starting point, at which time the Aussie was at US92 cents. Then the RBA was forecasting 2011 GDP growth of 3.75% and inflation of 2.75% (inside its 2-3% comfort zone). If the Aussie goes to parity now, that's roughly a 10% jump from 92, implying a trimming of GDP growth to 3.25% and of inflation to 2.15%. The RBA would be very comfortable with these numbers.
And that implies, suggests Macquarie, the RBA is happy at present to let the currency go to parity.
It's been a recent financial news highlight that the Bank of Japan has intervened to cap a rising yen for the first time since 2004. The BoJ has been forced to intervene in the yen on a number of occasions since Japan's economic collapse of 1990 for the simple reason Japan's economy is totally reliant on exports of manufactured goods. It is not unusual for other central banks to make similar currency market interventions to either cap or floor a currency. But not so the RBA.
The RBA does not have a history of such currency intervention. The RBA has nevertheless been forced to step into the currency market in recent times, particularly post-GFC, to “smooth” currency movements, and as Macquarie suggests has probably been in recently building up a few USD reserves. The RBA is not trying to influence the direction of the currency, it's just trying to keep a lid on potentially destructive volatility driven by herd mentality.
Again, this is reason to believe the RBA will not act to prevent the Aussie reaching parity. In turn, this implies the Aussie is not yet “too” strong that the RBA would consider holding off on monetary policy tightening. National Bank economists this morning revised their view in that an October rate rise has become a real possibility again, despite the futures market currently ascribing a 40% chance (November 70%).
With the Fed threatening QE2 to fight deflation, and the US dollar index looking technically weak once more, Aussie parity is not a stretch of the imagination.
Indeed, Macquarie's view is that if the RBA's economic growth forecast for 2011 (which is actually more bullish than its own) proves correct, the RBA will simply welcome a rising Aussie as an additional dampener alongside monetary policy, rather than a substitute for it. The trick is, of course, that were the RBA to hold off on raising rates because of the Aussie then the Aussie would fall. So it's not really like the two can be used against each other because they are mutually inclusive.
Yet were the Aussie to sail through parity and up to US$1.10, at that point the impact would be to push GDP growth below trend and inflation below the RBA comfort zone, as Macquarie notes based on the RBA modelling above, in which case it would be that actual interest rate cuts would be needed to prevent a return to unemployment growth.
In the meantime, investors should be wary of those listed Australian companies which rely heavily on receipts in US dollars, particularly if they do not have offsetting costs in US dollars. Analysts are yet to make up to date currency adjustments.
In the case of resource stocks, as noted above earnings will be impacted by the stronger Aussie unless commodity prices rise in USD terms by an equivalent amount. Listed metal prices have only risen collectively about 7% in the period the Aussie has jumped 13%, but bulk commodities are subject to the next round of quarterly price-setting. Previously, resource analysts had been expecting a pullback in Q3 and Q4 iron ore and coal prices over the heights of Q1 and Q2, but export volumes have proven relentless, and recent data do not indicate a significant slowing of the Chinese economy. In short, the next round of pricing is a bit hard to predict.
So one must not fall into the trap of assuming a strong Aussie dollar is necessarily a good thing. It might mean cheap overseas holidays and cheaper 3DTVs but it is also, for example, crippling the Australian tourism industry (once Australia's second biggest “export”) and is proving yet another kick in the guts for farmers who finally have abundant crops and strong USD prices to otherwise cheer about.
