Will the Aussie’s Slide Deepen?

September 18th, 2014
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Investing Daily Article of the Week

by Ari Charney, Investing Daily

The Australian dollar has enjoyed an incredible run over the past 13 years. Since its bottom at USD0.4856 in early 2001, it’s risen as high as USD1.10 in mid-2011.

But this week, the aussie has suffered what amounts to a plunge in the world of currencies, dropping from last week’s close of USD0.9378 to USD0.907 (at time of writing), its lowest level in six months.

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Even the surge in job creation, which we’ll discuss in greater detail in the forthcoming issue of Australian Edge, was not enough to overcome negative sentiment from the weakness in the prices of key commodities, such as iron ore and coal.

And given the strong correlation over the past year between Australia’s exchange rate and US Federal Reserve policy, it’s worth considering where the aussie might be headed next.

After all, the conclusion of the third round of the Fed’s so-called quantitative easing, colloquially known as QE3, is imminent, and many economists expect the US central bank will raise short-term rates by the middle of next year.

Investors who were early to Australia’s resource boom were fortunate enough to experience the tailwind of a rising currency, which further enhanced both their gains as well as the income they received from their dividends.

But more recently, the aussie’s resilience has posed challenges for the country’s exporters and the economy as a whole. Now that mining investment has peaked, the Reserve Bank of Australia (RBA) is hoping its monetary policy will help the non-resource sectors find sufficient growth to drive the economy.

To that end, the central bank has been on a rate-cutting cycle since late-2011. But it wasn’t until the Fed announced in the middle of last year that it was planning to curtail its extraordinary stimulus that the aussie began to decline in earnest.

The exchange rate fell as low as USD0.8682 by late January, but then much to the consternation of the RBA, whose governor has attempted to talk the currency lower on occasion, the aussie renewed its ascent. In fact, since the beginning of April, the Australian dollar has traded in a range between USD0.92 and USD0.95.

In the central bank’s latest policy announcement earlier this month, Governor Glenn Stevens said the aussie “remains above most estimates of its fundamental value, particularly given the declines in key commodity prices.

The latter part of that statement points to what has been one of the primary sources of the aussie’s strength, which is the perception that the currency is backed by hard assets courtesy of the country’s resource riches.

But the Australian dollar also gets a considerable boost from the fact that the RBA keeps short-term rates relatively high compared to its developed-world peers. For instance, even though the central bank’s benchmark cash rate is at an all time low, at 2.5 percent it’s still markedly higher than equivalent rates at many of its counterparts.

The reason for this approach is because Australia tends to run persistent trade deficits, so higher rates help attract the inflow of foreign capital necessary to finance them.

Indeed, the aussie is one of the currencies that figures prominently as the long component in the carry trades of numerous financial institutions and hedge funds around the world.

Put simply, the carry trade involves shorting a low-yielding currency such as the euro and using the proceeds to invest in a higher-yielding currency such as the aussie. This trade can also pair debt denominated in each currency.

Investors generate income from the spread between the interest rates of the two currencies, but can also speculate on whether the higher-yielding currency will appreciate, which can occur when other traders pile into the same bet.

These entities can also try to magnify the income they receive from the spread by leveraging these trades five to 10 times over, turning a 2.5 percent interest rate differential into 25 percent, for example.

The carry trade tends to work best during periods when volatility in exchange rates is low, which decreases the chance of the trade coming undone when currencies make unexpected moves.

As Westpac Chief Economist Bill Evans recently observed, “With low volatility, traders believe that commodity currencies which are overvalued in a fundamental sense can maintain that overvaluation while markets remain calm.”

And he believes the end of QE3, which could happen as soon as next month, could be a source of volatility since that’s what happened when the Fed wrapped its two earlier rounds of quantitative easing.

Although currency markets soon settled down again after those two earlier episodes, that might have been because traders were expecting more stimulus. This time around, however, the Fed’s next big policy move will likely be a hike in short-term rates.

In other words, currency markets could remain unsettled for at least the next several months, if not longer.

At the same time, while economists expect the aussie to decline over the next several years, the consensus forecast is not that much lower than where the currency trades presently. According to Bloomberg, the average projection is for the exchange rate to fall to USD0.88 next year and then trade around USD0.87 from 2016 through 2018.

Although those levels are well off the aforementioned 2011 high, they’re still high by historical standards and likely uncomfortably high by the RBA’s standards.

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