There are many challenges facing the incoming Australian government. Domestic growth is weak, business sentiment is poor and hiring intentions are soft. There’s the challenge of balancing the books, getting the budget back towards surplus, the self-imposed limitations on government spending and quite possibly the navigation of a fractured Senate where legislative approval is controlled by minor parties.
One of the key things that the incoming Australian Government won’t be worried about is the Australian dollar. It’s widely tipped to fall to US85c with Credit Suisse even suggesting it will fall to US75c. If the currency does fall — as anticipated by the market and as hoped for by Australia’s Reserve Bank — then the rebalancing and stabilising effect it has on the economy will make the next 3 years of government and economic growth all the easier.
But currencies and markets don’t always do what a central bank or government wants. So it’s worth looking at what has driven the Aussie dollar lately and what the outlook might be for the next year. The dollar is in a new cycle and its performance could have a dramatic impact on how public expectations need to be managed on the budget bottom line.
For a couple of years the Aussie consistently sat above parity against the US dollar. This was useful during the mining investment boom because it restrained domestic consumption, spreading it offshore as Australians plowed their hard-earned cash into holidays and internet purchases.
The RBA could keep rates lower than if the Aussie had been weaker, and more dollars had been spent on Australian stuff. It was also a very welcome restraint on inflation.
But since April the Aussie has fallen by around 17 cents to a low of US0.8846c last month before its recent tentative rally.
That’s a lot of volatility for the currency of a country that is still growing relatively healthily above 2.5%, has a benign inflation outlook of a little more than 2%, whose current account deficit is not too bad in the 2-3% of GDP region, and whose interest rate structure is still fairly high by global standards.
It’s possible the incoming government – likely to be an Abbott-led Coalition – will have to deal with a dollar that not only fails to stabilise growth, but puts the brakes on it. Policy can only do so much; on any given day myriad things drive a currency’s value on the market. There are trade flows, investment flows, government purchases, M&A, traders, hedgers and so on. The inputs into the decisions that these actors in the foreign exchange markets make constitute an even bigger cornucopia of drivers.
What’s driving the AUD?
When it comes to the Aussie dollar, I reckon you can distill all these hundreds of inputs and drivers down into five key areas. In doing so you can get a good feel for why it does what it does, why it was so strong and then weak while the Australian economy didn’t move that much.
The five key drivers are:
- global growth;
- interest rates;
- investor sentiment;
- the US dollar, and
When viewed through the lenses that are these key drivers, you can always get a good sense of why the Aussie is doing what it’s doing. More often than not you can get a sense of where it is headed on a macro time frame.
Take for example the last five months. The Aussie lost more than 16% of its value from above 1.05 against the US dollar. What drove it, and why, as BlackRock MD Michael Trudel said in June, were hedge fund managers forming a queue to short the Aussie dollar?
It’s simple really: BRIC economies (Brazil, Russia, India and China). They might not be among the five drivers listed above but they’re an important input into two of them: global growth and investor sentiment. The BRICs, particularly China and Brazil, were the engine of growth which balanced out the collapse in developed economies during 2009-11. Money flowed into these economies with abandon and investor sentiment was comparatively ebullient towards the profit-making opportunities in these emerging markets.
But the linkage with the Aussie dollar goes deeper – the BRIC’s were a safe harbour in the global economic and financial storm of 2009-2011, as was the Australian dollar. Australia was viewed by sovereign wealth funds, central banks, family offices and your run-of-the-mill portfolio manager as the developed world safe harbour with relative strong growth and relatively high interest rate.
The Aussie rallied up above $US1.00 to a high of $US1.1080 against a low of $US0.5960 in the dark days of 2008 after the collapse of Lehmann Brothers.
The period of the Aussie dollar as a safe haven is neatly summarised by the box as in the chart above.
But for central banks and other investors who were relatively new to the AUD and Australian assets, the Aussie wasn’t necessarily a safe haven but a port in the economic storm.
What these buyers were seeking to do with these purchases was protect their capital amongst the global turmoil and when the weather lifted, much of that money left, as the chart below of the Citibank Economic Surprise index shows.
The key here for the flows out of the Aussie is twofold:
- The developed world is healing so the need for a safe harbour is lessened; and
- The BRIC’s have stumbled leaving the Aussie dollar as a proxy for these currencies
So investor sentiment toward the Aussie falls, and money flows out – a story that is graphically borne out in this chart, which shows the synchronised fall in the Aussie with the weakness in BRIC growth data flow.
Even after a 15%, five-month fall, the RBA said in September that:
It is possible that the exchange rate will depreciate further over time, which would help to foster a rebalancing of growth in the economy.
The Australian dollar floated in December 1983 and has played an important role in stabilising the Australian economy by rising and falling to complement the Reserve Bank’s monetary policy when facing Australian and global growth.
The question for the RBA and the incoming government is whether the Aussie is going to continue to play that stabilising role, or if global forces – the improvement in developed nations and BRICs – will drive the Aussie back up into the mid-$US90c region.
If that is the case, then rates might need to head to 2%.
Greg McKenna is an active currency trader – he is small short AUD on a short time frame with a very tight stop.