Currency traders were right to trim the value of the Australian dollar on comments by Reserve Bank governor Glenn Stevens that the central bank still thinks the Australian dollar is too high, and remains "open-minded" about intervening in the markets to try to push it down.
On Friday, the dollar was trading about US92.4¢. That was above a low of just more than US89¢ at the end of August, but US0.5¢ down after Stevens' speech on Thursday night, US4.5¢ below a mini-peak of just more than US97¢ in late October, and US13¢ below April, when it finally began adjusting to weaker commodity prices.
That's about the right weight. Stevens didn't indicate an immediate attempt to wade into the markets and swap Australian dollars for foreign currencies, creating sell-side pressure on the dollar in the process.
What he did make clear, however, is there is a risk-reward trade-off for doing so - and it has moved in the central bank's favour. Stepping in to sell the dollar not so long ago would have been the equivalent of jumping in front of a runaway train, and that is no longer the case.
Stevens said buying or selling the currency when it moved on either side of its "equilibrium" value became more risky as the resources boom expanded, and the global crisis resulted in interest rates in northern-hemisphere countries falling to zero, opening up a profitable currency "carry trade" into Australia, where rates are more attractive.
A question arose about whether a new equilibrium value for the dollar had been created. The currency was probably still above its longer-term equilibrium value, he said, but it was not entirely clear what the new equilibrium was. The forces that had pushed the dollar up in the past half-decade were unlike those at work in the first 25 years of its life as a floating currency, and were very powerful.
Stevens was talking about balance-sheet valuation risk with those comments - the risk of asset value write-downs if it sells the dollar and buys foreign exchange only to see the dollar rise further. Before any new buying, the Reserve Bank owns about $36.6 billion of foreign currency. A 10 per cent rise in the dollar's value would create a paper loss of about $3.6 billion on that base alone.
He also noted that there is also a direct revenue and profit hit. If the Reserve Bank sells Australian dollars and buys foreign currencies, it is swapping money that is earning about 3 per cent, and buying money that is earning zero per cent, or very close to it. That is a loss-making "carry trade", the reverse of the profit-making carry trade that has been sucking international capital into the dollar.
Stevens went on to discuss cost-benefit equations on intervention. It might be argued, he said, that the negative carry created by selling the dollar and buying foreign currencies and the accompanying "very large valuation risk" were "a price worth paying" if intervention corrected "a seriously misaligned [that is, overvalued] exchange rate."
Intervention might turn out to be profitable in the end, he said. That would be the case if it assisted in a sustained decline in the value of the currency. The larger point, however, was cost-benefit sums had to be considered along with the likely effectiveness of intervention. So far, the Reserve Bank had not been "convinced that large-scale intervention clearly passed the test of effectiveness versus cost", he said.
He then said what the currency traders seized on. "That doesn't mean we will always eschew intervention. In fact, we remain open-minded on the issue. Our position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful. It can't make up for weaknesses in other policy areas, and to be effective it has to reinforce fundamentals, not work against them. Subject to those conditions, it remains part of the tool kit."
If the Reserve Bank wants to try to push the dollar down by exchanging it for foreign currency, it can. It owns the printing presses, so has an unlimited supply. Dollar-buying operations, on the other hand, are limited by the amount of foreign currency the Reserve Bank has to sell - $36.6 billion at the end of October, the same amount it owned at June 30.
The dollar is, however, a very deep currency market, the fifth most heavily traded in the world. It could take a lot of money to move it. The Swiss National Bank sold about 175 billion Swiss francs and bought foreign currencies worth about $US191 billion in 2011 and 2012 to halt a rise in its currency, for example. That was about a third of Switzerland's annual gross domestic product: a similar dollar selling operation here would be worth $500 billion.
The Swiss operation was, however, mounted when there was a massive, one-way river of money pouring into the Swiss franc as investors fled Europe's sovereign debt crisis. It was not easily sandbagged, and when the Australian dollar was soaring, the task would have been just as daunting.
There is not enough selling yet to get the currency down as far as the Reserve Bank, the government and currency-exposed industries want, but there's enough to give a dollar-selling program more leverage.
Stevens is signalling that if it wants to intervene, the Reserve Bank should now get more bang for its buck. That changes the odds on intervention, and the markets are right to take note.