FYI | Jul 09 2007
By Chris Shaw
As with most markets, exchange rates have a tendency to overshoot in one direction before correcting back to the appropriate level. But in the view of Westpac Banking Corporation senior international economist Huw McKay this is not the likely trading pattern for the Australian dollar as the recent gains are fully justified by fundamentals.
Adding to McKay’s confidence is the fact on his calculations the currency remains below fair value, meaning it is more likely to post further gains against the US dollar than to undergo some form of mean reversion.
The broader market appears to agree, as in recent weeks the main feature of trading in the currency has been its resilience to bad news, such as the weaker than expected dwelling approval and retail sales data from last week. At the same time McKay notes the currency is performing above expectations when positive data is released, as was the case with the recent monthly trade figures.
This leads McKay to suggest the currency could move above US90c before approaching anything close to an overvalued level, particularly given the terms of trade and external balance data and global liquidity levels continue to offer support.
Liquidity is an important factor as the bank notes through history the periods of increased trading in the Australian dollar are typically related to increased buying rather than selling. Adding weight to this pattern is the currency has a positive correlation to the Japanese yen when global liquidity is rising, a trend that also appears to have further to run given current weakness in the yen implies the carry trade continues to be put on, so supporting liquidity levels.
Given the returns the carry trade offers and the fact Japanese investors can still make excess returns from selling their currency and investing overseas McKay regards the threat of a significant appreciation in the yen, and a decline in the Australian dollar as a consequence, as a latent rather than imminent threat.
Add in the likelihood of higher interest rates in Australia in coming months and the currency looks even more attractive, leading McKay to suggest any reversion to historical averages is likely to still be some time away.