Currencies | Mar 14 2012
By Greg Peel
Which came first, the chicken or the egg? It's an old chestnut, but sufficiently relevant in the current context of Australian dollar strength. Under normal circumstances, a nation's currency, via its exchange rate with the US dollar global reserve currency, is a reflection of the relative strength or weakness of that nation's economy. But in the past couple of years, a stubbornly high Aussie exchange rate has acted as a drag on the Australian economy.
Which would suggest the Aussie should fall as a result. But it hasn't. The greatest number of corporate earnings forecast downgrades over the past several quarters have occurred in the resource and retail sectors, along with what there remains of local manufacturing. A strong A$ undermines mining and energy receipts, kills off manufacturing competitiveness (which already suffers from high labour costs), and sends consumers offshore online to shop. Just about every night on the news we hear of more layoffs – manufacturing has been particularly hard hit, the financial sector labour force continues to be decimated due to low activity levels, and really one wonders when the first really big retailer redundancies will be announced. Is this a strong economy?
No, but we also know it's “two-speed” or whatever other tag you may wish to use. That's why the RBA is reluctant to cut rates again because despite a strong A$ the resource sector continues to fire up with massive capex programs and the spillover into services of all varieties – from direct resource sector services right down to beer sold at the Karratha pub, the price of coffee in Perth, and possibly the only thing keeping our domestic airlines aloft – means the unemployment dial is little moved and nor is the central bank.
In the past however, back in those “normal” times, the Aussie dollar exchange rate has acted as a shock absorber on shifts in Australian economic fortunes. Big tumbles in the A$ during the 1997-98 Asian Crisis/Russian default/LTCM collapse period, the 2000-01 techwreck and 9/11 and the 2008-09 GFC all prompted big and rapid falls in the A$ at a time the Australian economy was much threatened. Each time the weaker currency acted as a dampener on potential economic hardship – flash new electronica might have become expensive but our exports became more attractive and our A$ corporate earnings more handsome as a result.
On the flipside, in times when the Australian economy has been strong, a rising A$ has worked the other way and provided a tightening effect enough to keep a bit of a lid on RBA rate hikes. That is, after all, the way it is meant to work.
It's not how it works right now. For decades, the A$ has been viewed by the world as a “commodity currency”. Whenever the prices of commodities go up, so does the value of commodity-rich Australia's currency, and vice versa. When the A$ really wallowed in the doldrums of near the US50c mark, global commodity demand was stagnant. A recovery to parity with the US has required the emergence of China. On that basis, the A$ and the Australian economy in general has become a proxy for investment in China. And as a strong China has encouraged global risk appetite, the Aussie has become the “global risk indicator”.
But not at the moment. Over the last twelve months, the A$ has risen and commodity prices simply have not. China's economy has slowed and, by virtue of a new 7.5% GDP target, should slow further. All last year the European crisis threatened to completely derail global risk appetite, and despite supposed Greek resolution opinions on Europe remain very much on the nervous side. Yet the Aussie remains as high as it's ever been post-float and can't seem to find any reason whatsoever to retreat. Why?
If we turn to foreign exchange 101, we learn that currency exchange rates are a simple reflection of global interest rate differentials. Something called “covered interest arbitrage” means that if you can borrow cheaply in one country and invest for a profit in another, risk-free, then the exchange rate between the two must adjust so that by the time you convert your profits back into your home currency they disappear. Otherwise you'd do it all day.
The problem is, forex 101 does rather live in that perfect world so popular with theoretical economists. One only need look at the persistent “yen carry trade” of the last decade to see that foreign exchange relationships are not quite as rapid-response as one might expect when gaps are huge and risks are prepared to be taken. For many years Japanese pension funds could borrow yen at basically nothing and invest in Aussie bonds at 5, 6, 7% for a spread so wide the occasional shifts in exchange rate were not too much of a problem. Indeed, such carry trading acted to keep the gap open and stable as long as the buyers didn't desert. Every now and again they did, and for short periods losses were substantial.
To call the Aussie a “commodity currency” seems to imply interest rate differentials have little to do with it, but that's not quite true. High commodity prices mean strong Australian GDP means higher interest rates means higher interest rate differential. It's just that exchange rates move one helluva lot faster than central bank policy-makers do, thus effectively anticipating changes in the interest rate differential well before they happen.
Why are things different this time? Or are they? Macquarie's forex forecasters had earlier assumed the A$ must come under pressure from a possible Greek default, slower China and further RBA rate cuts as a result. They had set their end-2012 forecast level at a mere US$0.93. This morning they raised that to US$1.10. And they don't see the A$ falling below parity now until 2015.
That's not what we want to hear. But Greece appears to have been at least temporarily resolved and the European threat has much eased now that Mr Draghi of the ECB is up all night printing new euros. He wiles away the hours chatting to Ben Bernanke who is in much the same predicament, even if Ben is currently only rolling his cash over. They chat about how everyone was so scared for the last two years of a slowdown in China, yet now that China is slowing in an orderly fashion commodity prices are still holding up (if no longer rocketing ahead, except for oil). And they debate the actions of their mate Glenn Stevens who has called the “two-speed” economy a “structural change” and is wary of making further rate cuts.
What Glenn has to consider is what is going on in Canberra. A spate of natural disasters aside, the Federal government is hellbent on returning the Australian budget to surplus and if the other lot get in, they reckon it can be done faster. In fact the other lot's major platform is the government's irresponsible approach to debt. When you have a surplus of funds, you don't need to borrow more from the investment markets. In other words, if ever we do return to surplus we won't need as many Aussie government bonds to be issued.
Macquarie notes that foreign ownership of Aussie bonds is now around 75%. And the buyers have not only been Japanese pension funds and US pension funds but other central banks and sovereign wealth funds. The current benchmark Aussie ten-year bond yield is around 4%. The equivalents in the US, Germany and the UK are all around 2%, and in Japan 1%. But that's the investment maturity. Compare short-term borrowing rates using central bank cash rates as a proxy and you have 4.25% versus zero, 1%, 0.5% and zero respectively. In other words, one can borrow short term money offshore for next to nothing and invest in Aussie bonds at 4%. If all goes well, roll over and do it again. The risk is that the A$ suddenly collapses and you are blown away on the exchange rate but the more the world goes the same way, the more pressure there is on that gap to remain open.
All around us, AAA-rated sovereigns are dropping like flies. The US is no longer AAA and the UK is on negative watch. Australia (and New Zealand too) stands out like a beacon for safe sovereign investment in a world in which the word “sovereign” now causes nervous goosebumps.
Then there's the stock market. If you are a US investor, for example, seeing the Australian stock market as a good proxy for Chinese investment, then you have the chance to “win twice”. You buy BHP at a certain exchange rate and both the price of BHP shares and the exchange rate rises, giving you a double-whammy. The same is true on the downside of course, which is why we've seen some pretty horrendous A$ plunges since 2008.
Lately, however, the A$ has just been high and stayed there. There's not a lot of incentive for US investors to buy BHP if the Aussie is already strong and may have more downside potential than upside. This becomes apparent when we look at the poor performance of the ASX 200 since last year's bottom compared to the S&P 500. Although we do know that the mining services sector has been a runaway success story in that period. Why? Apart from the obvious driver of resource sector capex spend, resource service companies tend to be excellent dividend payers.
And that's where the foreign money has been going – into Australian yield, both bond and stock. Another reason why the A$ has remained elevated. Move away from the financial markets per se, and Macquarie notes the Qatari sovereign wealth fund includes a food security division which has been busy buying up Australian farming operations.
The rest of the world loves us, and everyone here is bitching and moaning. No one wants to visit of course, because it's just too damned expensive. There goes the tourist industry.
Even if the Greek solution this time proves a successful one, or if in general Draghi's presses keep the European crisis at bay, economists are assuming the US dollar must appreciate as the euro falls. Quite simply, the US economy is improving as Europe spirals into austerity-driven recession. A weaker euro to a stronger greenback would mean a stronger US dollar index, and one might assume a stronger greenback must imply a weaker Aussie. But the Aussie isn't actually in the US dollar index (pounds, yen, euros, Swiss francs, Swedish kroner, Canadian dollars) and besides which, the relationship between the euro and the greenback is separate to that of the greenback and the Aussie. So the US dollar index could fly high and the A$ not move.
It's hard to see the A$ falling anytime soon when Bernanke has promised as good as zero cash rates out to 2014. Which goes a long way to explaining why Macquarie can't see any easing of A$ pressure until 2015. That and the fact we still sell everything to everyone in US dollars. And the Aussie against the euro is unlikely to fall while the ECB keeps up the cheap loans, nor against the pound or the yen while those central banks churn out the fresh banknotes as well.
The interest rate differential alone is not enough to actually move the exchange rate, one must have physical transactions to provide for actual foreign exchange and exchange rate setting. That's where those foreign investors come in – in bonds, stocks, farming land and whatever else (let's not forget Chinese mining interests).
Those transactions will persist even as the high A$ chips away at Australia's economy, reducing corporate earnings and forcing up the unemployment rate. The RBA could lower the cash rate a couple more times and not make a lot of difference. Only when the global tide turns will the Aussie turn, and that will require QE around the globe to end and a monetary policy tightening phase re-emerge to combat inflation risk. This assumes no hard landing in China, which seems to be less and less of a concern each month, and no further European disaster, the risk of which is lessened by money printing.
Macquarie still sees the Aussie back one day at a globally balanced level of around US$0.80. But not until after 2015.
Sorry.
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