|Summary: The calls for an Australian dollar drop are becoming louder from economic forecasters and currency traders. But, with continued high demand from traders, and our strong terms of trade, the dollar is unlikely to fall sharply in the short term.|
|Key take-out: A more probable outcome is that the $A will ease back to a lower trading range, with good support in the high US90c range.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
The Reserve Bank of Australia’s more explicit currency target has led to a flurry of activity in the exchange rate forecasting game.
Legendary investors such as George Soros (prior to the RBA’s cut) and Stanley Druckenmiller, very publically put bearish bets on the $A, with Drukenmiller stating that the $A would fall hard. So far, over the last week or so, it has dropped 2.5 cents. Now, I outlined in a piece last year Make a Europe splash with Aussie cash why I was a medium-term bear on the $A. Whichever way you cut it it’s coming down. The big question, is when?
In addition to Soros and Druckenmiller, some domestic economists are also calling for the big fall now. In support, it’s quite clear the RBA will cut rates again and there is growing pressure for it to supplement that with direct currency intervention. Buy foreign exchange, selling Australian dollars.
More to the point, and one key reason why the RBA itself expressed surprise that the $A hasn’t come down further, is that commodity prices are weaker. Take a look at chart 1.
The chart above shows our bulk commodities (coal and iron ore) mapped against the $A. To the extent that you can use charts like these to determine a value on the $A (very difficult and highly subjective) a straight read would suggest an $A between US90 cents and US95c.
It looks even worse when you look at gold and the $A in chart 2 below.
Despite those two factors above (further RBA cuts and weaker bulk commodity prices) and my medium-term $A bearishness, I’m not quite sure that the $A is quite ready to slide just yet though.
On the rates side, the reason is simple. It comes down to the carry trade. The RBA can cut all it wants, but unless we have zero rates and start printing, the fact is the carry trade will always be against us. The carry trade works where global investors who have the ability to fund in the US or Japan, UK or Europe can do so at rates not too far from zero. They then use those funds to park cash in higher-yielding countries – such as Australia and New Zealand.
Now, even if the RBA chose to go down the printing path, and I’m not sure it will, we simply cannot take on the Bank of Japan, the Federal Reserve etc in the money printing stakes. Don’t laugh – but it comes down to supply and demand. Yes, yes. Economists and their supply and demand curves. But, jokes aside, it does.
Taken to its logical extremes, the reason why we can’t compete is because the RBA can’t support a balance of the same size that Japan, the US and the UK can. Or, in other words, we can never match the supply of loanable funds. The US has something like $2.5 - $3 trillion in assets (17% of GDP), the Bank of Japan is expected to have about $2.5 trillion (about 40% of GDP), and when you throw in the unlimited liquidity that the European Central Bank provides its banks and the Bank of England, you’re looking at a $13-14 trillion balance sheet – just over nine times the size of the Australian economy. Even if the RBA printed 50% or closer to 100% like the Swiss central bank, that gives us $750 billion to $1.5 trillion (one -two weeks’ turnover) to play with as an extreme case. Note that the best the Swiss could do was to cap their currency just off a record high, and it’s still about 20% overvalued, 60% by some measures. The $A in contrast is probably only 5-10% overvalued at its current level – as a worst-case scenario.
Secondly, while commodity prices have come off and these indicate the $A should be a bit lower, our terms of trade as a whole is still close to a record. Indeed, the terms of trade doesn’t really suggest much downside to the $A at this point, and I’d note that period of deviation of the $A from bulk commodity prices and gold (charts 1 and 2) aren’t all that uncommon.
So do I think the $A will slide? No. Well maybe temporarily. As I’ve highlighted in past pieces, there is certainly a tendency for the $A to fall in the build-up to and in the initial phases after the RBA cuts rates. The problem is that it bounces back. When I look at the positions of traders in the lead-up to the RBA’s latest decision, it seems to me that this is probably going to happen again.
Take a look at chart 4. Even prior to the RBA’s decision net long positions on the $A had been cut hard. Now that of course reflects the change in market pricing; the government all but announced that rates would be cut and markets themselves increasingly began to price in further cuts, although most economists expected a June cut.
Having said that, it wasn’t the case that the market was short the $A. It’s more that longs dropped out of the market. In fact, nearly all the deterioration in net long positions reflects longs (or bought $A positions) falling rather than short (or sold positions on the $A) increasing. This is important because it indicates that the market is just making a tactical decision to exit long trades while the RBA cuts, rather than any change in strategy. In other words, the market doesn’t seem to have changed its view on the relative attractiveness of the $A. The $A is still attractive, which is why we haven’t as yet seen a surge in short positioning.
That’s not to say that I think the RBA’s explicit $A target will be completely ineffective. I think the major implication is that the $A will trade on a new and slightly lower range – we’re not heading back to $1.10 – and while the RBA cuts, it’s unlikely that we’ll hit $1.07. Maybe resistance at $1.05 will revert with plenty of support proved in the high US90s.
Ironically, this is probably a key positive for our market and something that, for domestic investors, should ease concerns of a major equity rout. Why? Because the fact is the high $A bodes well for the stockmarket. Take a look at the chart below– you can see there is a decent correlation.
Historically, there‘s actually been a positive correlation between our stocks -- miners even -- and the $A. See Tim Treadgold’s article Mining the dollar’s devaluation. Admittedly, for the miners, this has broken down since 2011 – the $A has remained high while our miners have come off.
The real problem will be if the $A does come off as well, because if it comes off hard it can only be because the economy is actually weak. And the economy will only be actually weak if the commodity boom is really over, China is really in trouble, and the global economy more broadly is turning down.
No, in contrast to the popular belief, a weaker $A will actually be a bad omen and herald difficult times to come. Luckily, recent data shows the Chinese economy accelerating and jobs growth is surging in the US and Australia – hardly signs that the economic backdrop is deteriorating.