How high can the Aussie dollar go?

The end of the Reserve Bank's cutting cycle, US budget reforms and a stabilising global economy and all set the stage for a stronger local currency – and it could lift as far as $US1.25.

Businesses, consumers and the Reserve Bank of Australia should think about the possibility of the Australian dollar going to $US1.25 in the next year or two. It could even go higher if the US dollar is further eroded by less gloomy news out of the eurozone, more political ructions from US Congress over the debt ceiling and further fiscal policy reforms.

With the world economy looking like it is moving into a decently stable growth phase, the domestic economy looking to pick up solidly through the course of 2013 and the Reserve Bank's interest rate cutting cycle getting close to an end, the current surprise would be a sharp Australian dollar fall.

Right through 2012, a run of what would normally be bearish or negative news for the Aussie was brushed aside from global investors, exporters and speculators alike. The Australian dollar ended 2012 stronger than it started it. It also seemed that the interest rate cutting cycle from the RBA and falling commodity prices would have pulled the rug out from under the unit, but each time there was a bit of a dip fresh buyers emerged.

It seems the lure of what was still a quite wide interest rate differential in Australia’s favour and the rolled gold attraction of the triple-A credit rating from all three major rating agencies was enough to encourage Australian dollar buyers.

It is worth recalling that there were four cash rate cuts totalling 125 basis points during 2012, and the vast bulk of these rate reductions were not anticipated by financial markets. The Reserve Bank's index of commodity prices fell 8.5 per cent in US dollar terms during 2012, which would normally be enough to knock a good 5 to 10 per cent off the level of the Australian dollar – instead, it rose 2 per cent through the course of the year.

The unrelenting Aussie buoyancy left most analysts and the Reserve Bank with the view that the unit was unjustifiably strong relative to fundamentals – overvalued in other words. This meant the Australian dollar was imparting inappropriate economic restraint on parts of the economy and helps explain why the economy ended 2012 with a softer tone and very low inflation.

During 2012, the Australian dollar spent only about 25 trading days below $US1.0000. And it averaged $US1.0360 for the year, a touch lower than where it is this morning.

A move back to $US1.10 and then to $US1.20 or even $1.25 is predicated on an improving global economic outlook and with that, higher commodity prices. There also seems to be a base forming from what was a temporary air-pocket for economic growth in the latter part of 2012. With monetary policy now on the easy side, the domestic economy should gain momentum from about now, driven by housing and consumer demand.

While the Reserve Bank is still likely to trim official interest rates once or perhaps twice more, the odds favouring those rate cuts is rapidly diminishing and indeed, the end of the current interest rate cutting cycle is getting near. This means that wide interest rate differentials will continue to support capital inflows into Australia and direct investment into the Australian corporate world from overseas is likely to accelerate as global economic and market conditions improve. These are all reasons to think the Australian dollar will be well supported.

The US dollar itself is subject to weakness, not so much from any economic underperformance in the US but more from the rock-bottom assessment of the likes of the eurozone, for example, which only really has scope for an economic upgrade. The US dollar has generally been a weak currency in recent years, even though the country's economy has outperformed the eurozone.

If the eurozone is able to stabilise its economy and get some economic traction on the back of the European Central Bank bond buying or indeed, a quicker than currently expected repair of the weaker countries as austerity measures fade, the US dollar could be propelled yet lower. This would be a critical element underpinning any Australian dollar rise to $US1.25.

As with all market forecasts, there are considerable risks to this outlook. Domestically, the main risk could be the federal election which is scheduled for the latter part of the year. The election could throw up an economic policy agenda that spooks international investors. Indeed, policies that lower gross government debt or threaten to restrain foreign investment inflows could easily be triggers to erode confidence and spark Australian dollar selling.

That risk aside, a strong world economy, the prospect for rising commodity prices, no further narrowing in interest rate differentials and the maintenance of the triple-A credit rating could well underpin the Australian to new highs. While $US1.25 may seem staggeringly high, it is still well below the $US1.4875 level seen during 1974.