Aussie Dollar Closely Linked To Global Risk Appetite

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By Andrew Nelson

Back in mid December, the Australian dollar was sitting at around US90.5c, and while since then it has gone on to peak at around US93c, it is now down in the vicinity of US86-87c after a run of negative sentiment began to build up in the early part of February. Yet even at current levels, the AUD is about the most expensive it has been for 20 years versus other major currencies.

Westpac had been calling for a new year’s peak at around US96c before a 5-10c pull-back. The economists have now shifted their view, thinking the recent US93c peak is the best we’ll see for a while.

Back in December, Westpac chief economist Bill Evans predicted the reversal, but thought the Aussie weakness would be short-lived, as the market would have to recognise that Australia will continue to benefit from its unique position as supplier to the ongoing surge in Chinese industrial demand. He then went on to predict that the AUD would resume its up-trend through the latter part of 2010.

While Evans admits the recent peak was both lower and came earlier than he had expected, he notes the precise timing of the emergence of the risk aversion trade was always going to be hard to pick. “It is a sentiment driven phenomenon after all,” he reminds.

Current trading in global markets so far this year is a sure sign, thinks Evans, that we are now moving into that “risk aversion” period he predicted in December that would bring about said 5c to 10c swing.

However, there is a new ingredient in the mix, one that wasn’t there in December, when Evans made his last calls. Chinese authorities have begun to tighten the nation’s lending guidelines, which has raised global concerns that the authorities will over-tighten. As the past few weeks have shown us, equities markets the world over haven’t much liked this news. Evans notes that from Australia’s perspective, the news is actually encouraging.

With Chinese inflation sitting at just 1.9% compared with the high single digit rates when authorities last over-tightened in the 2004/08 period, Evans expects it is highly unlikely they will make the same policy mistake again. He predicts that the “appropriate management” of the current surge is likely to ensure that strong growth can be sustained for longer, and this will be highly supportive of Australia.

But when you add in the ongoing Greek tragedy, three consecutive and sizeable down weeks on the US stock market and conflicting economic messages emerging from the US and we are understandably seeing a pronounced turning away from risk. This sees Westpac lower its AUD target for June from US90c to US85c, which makes it an US8c correction from December. This is consistent with the bank’s previous assessment in all but timing.

Westpac is keeping its US95c target for the end of the year and Evans expects that the second half of 2010 will be a period where markets become much more relaxed about the probability of China successfully achieving a soft landing. However, Evans still has doubts the US economy will be consistently demonstrating an ability to sustain growth, given the stimulatory effects of fiscal packages will be waning even more quickly.

Yet once markets accept the inevitability of an eventual sustained recovery in the US and once China starts showing signs of that soft landing, risk appetite will return, he predicts. Evans points at the first half of 2008, when markets were still taking on risk despite the obvious difficulties being faced by the US during the early stages of the credit crisis.

The strategy team at Credit Suisse has had its own look at the Aussie dollar versus the USD, and relative to commodity prices. The analysts think the currency is still looking pretty expensive despite recent weakness.

In light of the recent weakness of the AUD, CS analysts have examined the leverage of Australian base materials companies to a falling AUD/USD. They note Incitec Pivot ((IPL)) is highly levered to the cross. The company’s transactional exposure is via fertiliser sales, which are priced in USD. The analysts also point out the company has a significant translational exposure from the acquired Dyno Nobel business. On its numbers, every 1c appreciation in the AUD/USD positively impacts the company’s earnings by approximately $13.1m.

On the other hand, Orica ((ORI)) is a beneficiary of a weaker AUD, with every 1% depreciation of the AUD versus all currencies increasing earnings by approximately $7m. WorleyParsons ((WOR)) also has leverage to a falling AUD given offshore earnings account for approximately 75% of total group earnings. Thus, the broker notes that every 1c change in the AUD, versus a basket of global currencies, affects the company’s earnings by $2.7m.

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