Oliver's Insights
PORTFOLIO POINT: Shane Oliver expects the Australian dollar will remain in the US68–80¢ range in which it has been trading since 2003. |
KEY POINTS:
- The recent fall in the $A has been driven by expectations of a narrowing interest rate advantage and “guilt by association” with a plunging $NZ.
- This is unlikely to be the start of a sustained fall. We see the $A remaining in the US68–80¢ range it has been in for the past two and a half years.
The sharp fall in the Australian dollar from nearly US76¢ in January to near US70¢ has led some to wonder whether we are now seeing the start of a declining trend. A weaker $A is good news for exporters because it boosts the value of their export earnings and their competitiveness in global markets; good news for companies competing with imports and good news for the Australian sharemarket generally because about 30% of earnings are sourced offshore.
However, it is potentially bad news for Australian consumers if the fall flows through to higher prices for imported goods (such as cars, clothing and many electrical goods). For investors, a falling $A means they would be better off in unhedged international equities (rather than hedged) because their value will rise inversely with the fall in the $A (partly reversing the losses caused by the sharp rise in the $A a few years ago).
Our assessment, though, is that the recent fall in the $A is just normal volatility. We expect the $A will track sideways in the wide US68–80¢ range it has been in since late 2003.
The recent fall in the Australian dollar has essentially been driven by two factors:
- Renewed expectations that Australia’s interest rate differential against other major currencies will continue to narrow. The interest rate differential compared to the US has narrowed from 4.25% two years ago to just 0.75% right now. Current market expectations are for the US Federal Reserve to go a bit further in raising interest rates, which will continue to narrow the gap. Meanwhile, the European Central Bank is gradually raising its interest rates and the Bank of Japan is moving to do the same. As Australia’s interest rate advantage narrows, there is less incentive for investors to borrow cheap in foreign currency and park it in high-yielding currencies such as the $A. This practice is often referred to as the “carry trade”.
- The $A has been caught up in a plunge in the $NZ. Ridiculously high interest rates in New Zealand (7.25% right now) have pushed their economy to the brink of recession and led to expectations the Reserve Bank of New Zealand will soon be cutting interest rates. This has seen the $NZ fall by about 12% this year. Because it is often easier to sell the $A rather than the less-liquid $NZ, it has been caught up in the cross-fire.
IN PERSPECTIVE
Some have argued the fall in the Australian dollar, at a time when commodity prices are still strong, is telling us global growth is about to collapse and that high commodity prices are living on borrowed time. However, there are few other indicators of any impending collapse in global growth or commodity prices. In fact, global growth seems to be strengthening due to stronger growth in Europe and Japan. Growth in demand for commodities remains strong relative to supply and because of other influences the $A doesn’t always move in lockstep with commodity prices. In fact it is worth noting the $A has been wobbling up and down between US68¢ and US80¢ for the past few years. A plunge in the $A from US80¢ to US68¢ between February and June 2004 did not usher in weaker commodity prices, in fact they continued to move higher.
A longer-term measure of fair value for the $A indicates that fair value is around US70¢. This is based on what economists call “purchasing power parity” (the assumption that exchange rates should move to equilibrate average price levels across countries). Of course, this is of little relevance most of the time because currencies can be blown well away from fair value for many years. As such, it is best to think of it as a guide in the form of a range and then to focus on extremes (see next chart).
THE AUSTRALIAN DOLLAR VERSUS FAIR VALUE |
After a recovery from an extreme low of US48¢ in 2001 to a high of US80¢ in early 2004, the $A has hovered around the top half of the valuation range ever since. This is likely to remain the case over the next year or two. There are several reasons for this:
First, developments in New Zealand are of little relevance to Australia and so won’t have a lasting impact. The Reserve Bank of Australia never acted as aggressively in raising Australian interest rates as the RBNZ did and there is no sign of any impending recession locally, in contrast to New Zealand. Whereas, the RBNZ is likely to move towards rate cuts in the months ahead, the RBA still has a tightening bias, albeit only a mild one. So to the extent the $A has been pushed down by “guilt by association” with New Zealand, this effect is likely to be reversed in the months ahead.
Second, Australia is likely to retain a reasonable interest rate advantage over the US, Europe and Japan for the foreseeable future:
'¢ US interest rates at 4.75% are getting pretty close to the top. US inflation still remains benign and a steadily unfolding housing slowdown will see growth slow below trend and take pressure off the Fed (just as it did in Britain and Australia last year). By year-end it is quite likely the Fed will be shifting towards easing monetary policy and investors will be starting to wonder about a renewed widening in the gap between Australian and US interest rates.
'¢ Although Japan is looking far healthier lately with inflation only just above zero, an interest rate hike may still be six months away. When the Bank of Japan does start moving, it will be relatively slow. By year-end Japanese interest rates, which are currently zero, are likely to be around 0.5% '” still 5% below those in Australia.
'¢ Similarly, the European Central Bank has little reason to get too aggressive. European inflation is just above 2% year on year on a headline basis, but after excluding food and energy is running around 1.5%. European rates, currently 2.5%, are likely to be just 3–3.25% by year-end. In other words, still well below Australian interest rates.
The chatter surrounding financial markets often has much in common with a never-ending soap opera. The big recurring issue over the past few years has been the return of global interest rates to more normal levels and the unwinding of the “carry trade” (which seems to keep getting unwound and rewound every six months!). Our assessment is that this issue will remain a recurring theme for some time because in a world of low inflation, the whole process of increasing interest rates to more normal levels will remain long and drawn-out.
Third, the commodity price support for the $A is likely to remain in place for a while yet. Demand for commodities is continuing to be fuelled by strong growth in China and India, at the same time that growth in industrial countries is robust, with Japan and Europe now coming to the party. At the same time, the commodity supply response remains slow by past standards. This reflects years of low levels of exploration, fewer economic discoveries and underinvestment in the mining sector.
COMMODITY PRICES ARE SUPPORTIVE OF THE $A |
Australia’s large current account deficit remains a risk for the $A, but it hasn’t played a major role over the past few years in driving the currency. In any case, it should start to improve a little over the next year as the long-awaited pickup in mining export volumes starts to slowly come through in response to an expansion in mining sector capacity. It is also worth noting the US current account deficit is now worse than Australia’s as a percentage of GDP (6% in the case of Australia and 7% in the US). Financing the US current account deficit now requires $US3.5 billion of capital inflow each working day whereas the Australian deficit only requires $US0.16 billion in capital inflow each working day. So in this sense, the $US is far more vulnerable to a change in investor sentiment towards it than the $A is.
CONCLUSION
The recent weakness in the Australian dollar is unlikely to represent the start of a renewed downtrend. Australian interest rates are likely to remain above global interest rates for the foreseeable future and commodity prices are likely to remain high. As such, our assessment remains that the $A will remain in the US68–80¢ range it has been in for the last few years.
Against the yen, euro and Asian currencies, the $A may be a little weaker over the next year as interest rates rise in these countries.
For investors in international equities, the case to be hedged from foreign currency back into Australian dollars is nowhere near as strong as it was back in 2002 and into 2003. But bear in mind there is still a case to retain some hedging. This is because still relatively higher Australian interest rates compared to global interest rates means investors are actually paid to hedge right now to the tune of about 1.8% per annum for a standard international equity product. So for an investor to lose out, the $A needs to sustain a fall of 1.8% pa or more.