Don’t depend on a dollar drop

A lower Australian currency is unlikely to cushion us against rising global interest rates … it may even exacerbate the problem.

Summary: The Australian dollar fell 3.3% over three days last week – and has since stabilised at this lower level. While it is uncertain whether it will break below the key support of US90 cents with indicators telling us traders are still reluctant to be too bearish on the currency, the question is now what does this mean for investors.

Key take-out: Investors shouldn’t rely on a lower local currency to insulate Australia against rising global interest rates. Our economy is heavily skewed to export growth and, more to the point, a sustained fall in the Australian dollar would almost certainly be met with the RBA hiking interest rates anyway.

Key beneficiaries: General investors. Category: Economics and Investment Strategy.

The Australia dollar fell three cents, or 3.3%, in about three days last week and has since managed to hold at this new level. Naturally, the question now is what does this mean for investors. And it’s not an easy one to answer.

Two problems come to mind. Firstly, the speed of the fall – the suddenness of it. Secondly, we have been down here many times before. The issue is whether it will be sustained and there are very good reasons for and against. The first real test will be if the unit breaks decisively below US90 cents.

Chart 1, below, shows that 90 cents has proven to be a key level of support – broadly, not exactly – and markets have been reluctant to take it below that level. So far in this sell off, the low has been US89.91 cents, however that level was only held for a few hours. That tells us that traders are still reluctant to be too bearish on the currency.  

Chart 1: Key support around 90 cents


Graph for Don’t depend on a dollar drop

But let’s take it as a given that the currency will fall. Will that cushion us against rising interest rates in the US and elsewhere? As the Aussie dollar has slumped, the US 10-year bond yield has risen20 basis points to 2.58%. While still low, it is a decent rise over a short period and highlights a growing nervousness that the Fed may actually start tightening rates. Indeed, markets are split on whether the US Federal Reserve will signal at its meeting (outcome known tomorrow morning) that a rate hike is imminent.

I don’t think the weaker dollar, if that is what we end up with, will cushion us against rising interest rates – if anything it will probably exacerbate the problem.

The main reason for that is because if the currency does fall further, domestic inflation will rise as well. Perhaps well above the Reserve Bank of Australia’s (RBA) target and a rate hike from them will almost certainly ensue – not immediately, but in time.

A lift in inflation doesn’t always have to be a problem mind you and it isn’t always met with a policy response. It’s very clear though that the Australian economy (while not without risks) has much more momentum than was widely thought in the market. GDP growth is above average, and jobs growth is robust.

That the unemployment rate has risen a little is simply a function of the fact that the participation rate has increased – and that is another positive, given that is shows workers feel more encouraged to enter the workforce.   I realise that the RBA’s assessment is that labour market conditions are subdued, but they will have to revise that view. The sheer magnitude of job creation, even allowing for the latest 121,000 gain to correct, already shows the RBA’s view on the market is incorrect. Recall that non-farm GDP growth is already about 1% stronger than what the RBA had forecast.

With that in mind, we are starting from a position where inflation is already at the top end of target and, just like with economic growth, is much higher than the RBA and others had predicted.  

What the RBA will do

All of this suggests that if the RBA is freed from its exchange rate target, then it will most certainly raise rates. Indeed in the RBA’s latest minutes the Boards expressed concern about rising house prices.

Think of it another way. The RBA is torn at the moment. With the exchange rate target the RBA would love to cut rates, but house prices are preventing them from doing so. On the flipside, if the currency was materially weaker, there would be no reason to have rates so low. Growth is robust, jobs are surging and inflation is elevated. The housing market is booming.

I think there will be other steps first though. I don’t think that if the Fed hikes that the RBA would immediately follow. I suspect that the RBA’s call on housing in the latest minutes was probably less a signal that rates are going up and more a signal that macro prudential regulation is about to be implemented. But rate hikes will follow when the board realises that macro prudential regulation has done nothing to stymie house price growth – and that the economy is again much stronger.  The timing is obviously difficult but I think that will be the order of events.

The much more important issue to note is that a weaker Australian dollar wouldn’t do anything to rebalance the economy anyway. That’s because growth is already heavily skewed toward exports. That’s a very important inconsistency that readers should note. What’s the point of rebalancing an economy that is already driven by export growth? The areas of growth that need to be stimulated are non-mining investment and consumer spending. A weak currency cannot help here and indeed may hamper growth, if anything.

Conclusion

To sum it all up then, it’s not likely that the falling Australian dollar would insulate us against rising global rates with some sort of growth offset.

This is because the economy is already heavily skewed toward export growth and a weaker currency cannot lift the remaining areas of the economy that need to lift: namely, non-mining investment and household consumption. More to the point, a sustained fall in the Australian dollar to 80 or 85 cents would almost certainly lead our own central bank to hike rates as well.

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