FYI | Jul 27 2007
By Chris Shaw
The Australian dollar may have lost more than a cent overnight against the US dollar but according to Westpac Bank global head of economics Bill Evans the currency’s direction remains up, with US92c likely by the end of the year.
This represents an increase of US7c to the bank’s estimate for the level of the currency at the end of the year, the change reflecting in part its decision to bring forward its expectations for further Reserve Bank of Australia (RBA) increases to official interest rates from February and May next year to August and November this year.
The increase also reflects what Evans sees as a purple patch for the currency in terms of other economic factors working in its favour, including ongoing improvements in the terms of trade thanks to strong commodity prices; an outperforming Australian equity market when compared to local peers; and favourable interest rate differentials, which make the Australian dollar a buy for those looking at the carry trade.
The expectation of further rate hikes only enhances this interest rate differential and so Evans sees continued strength in the Aussie dollar as likely, not least because it remains undervalued against the US dollar despite its recent gains. On his estimates, fair value for the currency stands at around US95c currently.
While not anticipating the currency will reach that level Evans sees it trading as high as US93c by June of next year. When the peak occurs remains difficult to determine as it remains subject to any peaking in commodity prices, and here he notes there will not be a clear indication if a peak has been reached until at least the middle of 2008.
Of course, last night’s action in equity and currency markets shows there remain risks to the bank’s view, the major risk according to Evans being a global credit event that results in a significant decrease in risk appetite among investors. While there have been and will be more losses from the sub-prime credit issues playing out at the moment Evans puts these in some perspective, noting while losses of US$40 billion to date and potentially another US$40 billion are possible, global equity markets have added more than US$2.8 trillion in capitalisation over the past 12 months.
Assuming there is some reduction in risk there is also scope for the carry trade to be unwound, which would see some selling hit the Australian dollar. Again, there was some evidence of this overnight as against the yen the Aussie fell sharply, trading down to around 102 yen against recent levels of more than 105 yen.
While seeing the Aussie dollar as stretched against the yen at current levels the interest rate differentials on offer in global markets lead Evans to suggest any significant unwinding of the carry trade is more of a potential threat than one likely to be realised anytime soon.