If there’s one thing that’s puzzled analysts over recent years, it’s been the persistent strength of the Australian dollar, even after its recent decline.
Interest rates have been cut by 300 basis points since late 2011, leaving the cash rate at a record-low level of 1.75%, while the prices for Australia’s key commodity exports have fallen with a thud, eroding national incomes courtesy of weaker terms of trade.
Although many may point to the ultra-easy monetary policy from the likes of the European Central Bank, Bank of Japan and up until recently the US Federal Reserve to explain the Aussie’s resilient performance, and rightfully so, Daniel Been, FX strategist at the ANZ, believes there is another significant factor that’s underpinned the Aussie of late: Australia’s prized AAA sovereign credit rating.
In a world of ever declining real returns, a safe, higher-yielding currency looks desirable to the rest of the world.
Perceived strength, particularly in recent years, has its consequences when it comes to asset flows, says Been.
“Over the past five years sovereign ratings have become a larger focus for currency markets,” wrote Been in a research note this week.
“This change has driven a shift in perceptions about the safety of the AUD as a haven currency, where the quality of the sovereign, rather than the broader economic construct, came into focus.”
Been cites prior concerns, which have now passed, to explain the increased reliance upon credit ratings to drive investor flows.
“First, when the US Federal Reserve enacted its first quantitative easing program, it drove fears in the market of debt monetisation and fears that runaway inflation would debase domestic debt holdings,” he says.
“Second, the existential crisis in Europe and the near collapse of the EUR as a common currency in 2011-12 led the world to search for an alternative reserve currency.
“Again, at this point, where the viability of a previously trusted sovereign was called into question, meant that the market searched for more viable ‘AAA’ sovereigns to invest in.”
It’s little wonder that investors flocked to Australian dollar, driving it to its highest post-float level against the US dollar in early 2011.
While credit ratings were deemed far more important in recent years, Been does not believe this trend will last, suggesting that “factors beyond the sovereign rating will ultimately determine the final path of the AUD through the end of this cycle”.
“When looking at currency markets, we would place far more emphasis on the level and change in debt of the entire economy and on the economy’s vulnerability to external conditions, than on the fiscal backstop that the government can provide,” says Been.
“On these counts, we continue to think that the AUD remains vulnerable.”
Pointing to the chart below, supplied by ANZ, Been suggests that a currency that a currency with a positive current account position, a lower external financial burden, less cyclicality, and a lower total debt burden should be considered a more appropriate safe haven than one which simply has a AAA rating attached to its government debt.
Based on these metrics, he notes that the Australian dollar doesn’t look anything like a safe haven, but rather something more akin to a riskier emerging markets currency.
“Australia ranks in the bottom two on the external measures – IIP and current account – and growth in its non-financial debt ratio,” he says, adding that it also “ranks in the bottom five for the level of private non-financial debt and also has a very high positive beta to global growth”.
So what could shake the markets reliance upon credit ratings, adding to downside pressure on the Aussie moving forward? Increased volatility, along with narrowing interest rate differentials between Australia and the rest of the world, says Been.
“Volatility can certainly play a role in removing this attitude from the market, and if risk-adjusted returns continue to deteriorate (interest rate differentials adjusted for currency volatility), we could find a threshold for how much forgiveness the market will allow for all of the above vulnerabilities,” notes Been.
“Any further divergence in interest rate outlooks for Australia and the US could take us back towards levels not seen since the last episode of extreme AUD weakness in 2000-01.”
That was the “Pacific peso” era, when the Aussie was trading below 48 cents to the US dollar, levels no one would associate with a safe haven currency.
Though Been is not forecasting that the Aussie will tumble to such levels, this is something to consider when evaluating where it’s likely to head, particularly as the US Federal Reserve is seemingly moving towards hiking interest rates again.