CBA Applies Parity Forecast For The Aussie

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By Greg Peel

One might be forgiven for being confused to learn that the Aussie dollar has entered a period of quite low volatility. It seemed for a while there this week we were leaping another US cent every 24 hours. But while there's been the odd surge lately given increased expectation of an RBA rate rise very soon, by comparison to the last couple of years Aussie volatility is now relatively low, the forex analysts at Commonwealth Bank point out.

In 2007 the Aussie saw (all values in USD) both 77c and 93c, in 2008 it saw 95c and 60c, in 2009 it recovered from 60c to 93c, and in early 2010 we saw 80c again before returning to 95c. Suffice to say that at the depth of the GFC the volatility on the Aussie hit a peak of 37% and now it is back to 12%.

The reason why Aussie volatility has dropped despite the currency threatening its highest levels since it devalued on the initial float in 1983 can be understood by dividing the drivers of the Aussie into two specific elements. The first is that which determines the value of any currency in times of market calm – economic growth, resultant interest rate differentials with the US and commodity prices, which in turn feed back into economic growth. The second is that which has driven the Aussie in recent years – the risk trade. The Aussie as a commodity currency and Australia as a major exporter to China means the whole world has been buying and selling the Aussie as a herd depending on risk appetite.

Two years out from the fall of Lehman, and even in the wake of the initial European credit crisis, the world's appetite for risk has settled down, meaning it is no longer flipping violently from “get me in!” to “get me out!”. Rather, the US economy is bungling along a sluggish growth line, the European economies seem to be controlled now under austerity measures and Asian economies are fuelling global growth. Indeed, despite sluggishness in the world's major economies, CBA's forecast for 2011 global GDP growth is 4.1% which is 8% above the historical trend of 3.8%. Clearly emerging markets are offsetting developed markets.

When risk appetite settles down, and the volatility of the Aussie settles down with it, the driving force behind the Aussie falls back toward the traditional comparisons of GDP growth and interest rate differentials. On that basis, we have a US Federal Reserve likely to implement further quantitative easing (QE), or at the very least keep rates exceptionally low for an extended period, and a Reserve Bank of Australia predicted to raise its cash rate any time soon. And perhaps to raise it as much as another full percentage point by end-2011.

Moreover, CBA notes the new Basel III banking regulations are less encouraging of risk taking than was the case prior, meaning Aussie volatility has less reason to spike.

Underlying Australia's now above-trend GDP growth is quite simply its commodity export industry, and with 70% of Australian exports now heading to Asia, a weak G7 is not going to upset the fact commodity prices will be supported by consistently strong Asian demand. Australia's terms of trade will thus remain consistently high for a while yet, suggests CBA. This puts upward pressure on inflation and thus interest rates.

While an increase in the US money supply (QE) implies a weaker US dollar, CBA suggests that an announcement of fresh QE might actually spark a jump in the greenback initially. The simple reasoning is that if the Fed thinks the US needs more QE then clearly the US is in trouble, hence risk trades will be unwound, hence money will flow back to the supposed safety of the reserve currency. It's ironic, but that's how things work these days.

But once the initial dust settles the greenback will continue its underlying weakness, CBA believes. By definition, this means more upward pressure on the Aussie dollar.

Prior to today's forecast update, CBA had the Aussie reaching 88c by end-2010 before falling gradually as the US economy slowly recovered – 87c by March 2011, 85c by June and 82c by September. But although CBA still is factoring in an US economic pick-up down the track, those numbers have now changed to 97c by end-2010, 102c By March, 99c by June and 94c by September.

So there it is – 102c or US$1.02. Not only parity, but 2c above it.

Investors are once again warned that stock analysts are yet to make similar adjustments. There was a little precursor this morning when UBS reduced its target price on US-based mining services company Boart Longyear ((BLY)) citing “higher A$ assumptions”.

Locally-based resource companies are at threat of currency-based earnings downgrades provided currency changes are not offset by equivalent commodity price increases. Base metal prices have remained firm and it is likely bulk commodity prices will as well, although we are yet to see the next set of settlements. Either way, investors are warned that there is a push and a pull going on here.

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