The Australian dollar remains a headache for domestic policymakers. Despite the best efforts of the Reserve Bank of Australia, including a rate cut earlier this month, the dollar jumped to a touch over US77c in trade late last week.
It marked the highest daily close for the dollar against the greenback since April 26 this year. During that time the RBA has cut interest rates by 50 basis points to a new record low of 1.5 per cent. Yet the dollar has been effectively unchanged over that period.
From an investor's perspective the relative strength of the Australian dollar can be a blessing or a curse. A higher dollar, for example, has historically led to stronger mining shares. A lower dollar, by comparison, supports manufacturing and tourism.
If you are an investor who likes to dabble in international equities, as I have in the past, then a depreciating currency can boost your return.
As a general rule, economic strength will typically lead to a stronger dollar and that normally means stronger equity prices and higher bond yields.
Nevertheless, the Reserve Bank finds itself in a position where it needs to drive down the value of our currency in order to facilitate Australia’s economic transition. With mining investment on the wane, we need greater activity across the non-mining sector in order to drive employment and spending.
Unfortunately, that isn’t really possible with a strong Australian dollar. Something needs to give, and that’s one of the main reasons why the RBA has cut interest rates to their lowest level in history.
Recent developments in foreign exchange markets
We tend to gravitate towards the US dollar when discussing the value of the Australian currency. Yet the relative strength of the Australian dollar can fluctuate wildly from country to country, depending on a variety of factors.
The graph below measures the change in the value of the Australian dollar against six key currencies, as well as the trade-weighted-index (TWI), since the beginning of the year. The TWI basically measures the value of the Australian dollar against the currencies of our most important trading partners, with our larger trading partners such as China possessing a bigger weight in the index.
It’s been an extraordinary year for the Australian dollar. A moderate appreciation against the US dollar has been more than overshadowed by a 20 per cent appreciation against the UK pound and a 12 per cent depreciation against the Japanese yen. In aggregate, the TWI has appreciated by 2.2 per cent.
As I noted above, two interest rate cuts appear to have had little effect on the value of the Australian dollar. But you could quite reasonably argue that in the absence of those cuts the dollar would be even higher.
Right now the Australian dollar is being bid higher due to a combination of stronger commodity prices, expectations that the US Federal Reserve will take a more cautious approach to policy normalisation, and quantitative easing and negative interest rates overseas.
Quantitative easing and negative interest rates continue to complicate foreign exchange markets. However the results haven’t always been as expected. The yen, for example, has appreciated against other major currencies, which is precisely the opposite of what the Bank of Japan was trying to achieve.
Real exchange rate
To understand why Australia needs a weaker currency we need to delve a little deeper into what the value of the Australian dollar represents.
To do that I want to draw your attention to Australia’s real exchange rate. The real exchange rate is basically a measure of the competitiveness of Australian businesses against foreign competition. It’s never reported on by the media and yet it is one of the most important indicators for the Australian economy.
At the end of June the real exchange rate remained 13 per cent above its long-term average (taken from the float of the Australia dollar in 1983). It has fallen 18.5 per cent from its peak in the March quarter of 2013.
Based on these figures we can safely say that the Australian dollar remains high by historical standards. It remains at a level that in the past has proved problematic for Australia’s non-mining sector.
Many Australian businesses across the non-mining sector simply aren’t competitive at current exchange rates and the longer this persists the more damaging it will be for those firms. That won’t change until the Australian dollar drops towards US65c.
The graph above compares Australia’s real exchange rate against our terms of trade. Our terms of trade is a ratio of the price we receive on our exports compared with the price we pay for our imports.
The relationship between the two is relatively simple. An increase in the terms of trade means that domestic households and businesses can purchase more imports for every unit of exports sold. This leads to a transfer of income from foreign countries towards Australia, boosting domestic demand and inflation, while also increasing the demand for the Australian dollar. The reverse is true for a decline in the terms of trade.
The fall in the terms of trade reflects the sharp decline in commodity prices, led by iron ore and coal. The depreciation in the Australian dollar during that period has helped to contain the damage caused by weaker commodity prices. In a sense the dollar is like a shock absorber that stops the economy from becoming too strong or too weak.
As you may have already worked out, the outlook for the Australian dollar will depend in large part on commodity prices. On average, over the past 10 years, iron ore prices have declined during the months of September to November. Ongoing supply growth will also put downward pressure on iron ore prices over the remainder of the year.
Don’t be surprised if the iron ore price drops from its current level of $US60 a tonne towards $US40-$US45 a tonne by the end of the year. If achieved this will drive the Australian dollar towards the US72c range and hit mining stocks in a big way.
Another important factor will be Federal Reserve's monetary policy. If it decides to hike interest rates in September or December, then it will put downward pressure on the Australian dollar.
The ongoing collapse in mining investment and the end of the liquefied natural gas mining investment boom will also lead to a reduction in foreign capital flows into Australia. Finally, China’s economic transition away from infrastructure investment towards household spending will put downward pressure on commodity prices over the next three-to-five years.
There are three complications.
First, increasingly loose monetary policy in major economies such as Europe, the United Kingdom and Japan.
Second, the Federal Reserve may delay an interest rate hike until next year.
Third, in a world that lacks sufficient AAA-rated assets, Australian government bonds remain in high demand for fund managers worldwide.
Each of these factors have contributed to Australia’s stubbornly high dollar and could prove problematic over the remainder of the year.