RBA governor Glenn Stevens has upped the ante on the Aussie dollar, suggesting it should fall, or at least that it would be desirable if it fell, to around 75 US cents. Currently at a little over 81.5c, the currency looks well on its way to hitting that target.
Why that is the target is unclear. While that may be the average rate since the AUD was floated back in 1983, so much has changed over the last few decades, there have been so many ‘regime shifts’ or structural changes that I’m not sure that average is relevant.
Indeed the economic theory or fundamental models of exchange rate determination are not united in pointing to 75c as fair value. Some models suggest it should be closer to parity, and it's intriguing that the RBA governor decided to rely on one of the least reliable models -- the law of one prices -- to get his 75c target.
If we just look at the economic backdrop, we can get a sense as to whether an AUD around 75c would be a good fit for the economy. Forecasting currencies is of course a mug's game, which is why it’s a job best left to economists -- frauds the lot of them. But it is, at the very least, an indication.
So for instance, the last time the AUD was sustainably around US75c was the period from 2004 to 2007. At that time commodity prices were 30 per cent lower than they are today. The terms of trade itself was about 22 to 25 per cent lower.
While the RBA like to make much of the fact that the terms of trade has fallen sharply, the fact is it is still very high relative to our history. Commodity prices are over 50 per cent higher than the average, and yet are our nation's policymakers, politicians and the herd of lacklustre economists are quivering with fear over this current rout. It’s embarrassing.
If policymakers are going to be honest about it -- and they haven’t been so far -- they would at least acknowledge that AUD should be higher than the average exchange rate given elevated commodity prices. Certainly strong than the 2004-07 period. Interestingly, that puts the currency just under parity.
The other issue of course, is that Australian interest rates remain much higher than in the US and elsewhere. The 10-year bond yield is 73 basis points higher than the US equivalent. Now it’s fair to say that differential has come in sharply from its peaks.
The spread is around half what it was only a year ago. At the same time though, it is a very positive-yield differential in a world that is hungry for yield, for anything that can offer a return. That kind of makes historical comparisons less useful when you’re looking at interest rate spreads.
It’s fairly obvious then that the AUD on its own merits should be much stronger than what we have seen in the past. Certainly 75 cents would appear ridiculous given the current backdrop.
Yet we’re not talking about the currency just on its own merits. The bigger issue is whether the USD will maintain its current rally. Remember that the slump in the AUD is fresh: only three months and it was sparked primarily by a sudden and unexpected surge in the greenback.
That the USD is rallying is what you’d expect. It’s a reasonable and rational reaction to an economy that is surging and leading growth in the advanced world. The big question is whether its done its dash.
The Dollar index has been stable for about a month now having increased by around 10 per cent against the yen and euro. That’s a sizeable appreciation and it may just have investors wondering about how that might affect future growth and policy outcomes. There comes a point where the strength of the currency acts as a sort of automatic stabiliser: something that will act to weaken growth, lower inflation and reduce the prospects for Fed rates hikes . All of which – naturally - is bearish for the currency. The key uncertainty, is whether we’re at that point.
Either way, at the current level of 81.5c, the AUD does look cheap relative to recent history. I suspect that many global investors, especially those US investors looking for precious yield, may find soon find the AUD irresistible and again pile in to Australian financial assets, which look very cheap in comparison. That doesn’t augur well for the RBA’s call for the AUD to slump to 75 cents. It may get there just on the sheer force of momentum, but it’s highly unlikely to stay there as policymakers seem to want.