Our dollar set to dazzle again

The Reserve Bank of Australia moved firmly into neutral territory this week, although when I say neutral, policy is in fact far from it.

Interest rates are at record lows. But it does at least look like the RBA is taking note of the lift in property prices, inflation and some of the partial indicators showing a rebound in growth. It is neutral in the sense that the next rates move, whenever that should come, could be up or down. For now though, the RBA states:

“Monetary policy is appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target. On present indications, the most prudent course is likely to be a period of stability in interest rates.”

So the best bet, from what the central bank has said, is that rates will be on hold for some time. In response to that statement the Australian dollar shot up. I presented some analysis last year as to why this might happen in Why our dollar may keep rising.

Readers may recall my concerns that the $A would rise as it became clear that the Australian economy wasn’t heading into a downturn. Many economists, and the RBA’s own rhetoric, had conditioned the markets to expect economic weakness. It was why the RBA was supposedly cutting rates. So it’s only logical then that as this narrative unwinds, or more reasonably as it becomes more apparent that this narrative was the wrong one, that the $A would rise – and by quite a bit by the looks of things. Take a look at chart 1 below.

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The Aussie dollar spiked over US1.5 cents on the day the RBA changed its policy stance.  Taking into account the impact from the strong retail sales figures, then we’re look at two cents in two days. That’s a decent move, but the question on everybody’s lips is where to from here? The way I look at it, there are a number of supporting factors for the $A.

The growth narrative and Aussie dollar expectations are changing

Unfortunately, one key reason why we’re seeing a stronger dollar is because the RBA, and others who wanted a weaker $A, really seem to have shot themselves in the foot. This is because they were trying to force down the $A by slashing rates and liking this ultra-loose policy to a weak underlying economy.

It was this constant fear campaign that eventually shattered confidence and spending in 2013. It became a self-fulfilling prophecy in 2013, following strong growth in 2012, although the truth be told, 2013 growth wasn’t really weak. Just a little below trend. Anyway, in 2014 we find that nearly all the economic indicators have turned: this week’s retail sales numbers are only the latest in a batch of domestic data that shows a sharp acceleration in activity.

The retail result itself is the best in years. We also know that the housing market has turned and that there is still $200-$300 billion worth of resource investment still to be completed.

For more on the latest economic data, see Shane Oliver's article Good news on the economy.

The Australian dollar was oversold in any case

Even after this week’s two cent rise, the Australian dollar looks to be very oversold. Think of the dynamics confronting the Australian dollar at this point. In effect, the Aussie dollar, whether measured against the US dollar or on a trade-weighted basis, is back down to where it was when the world’s economists were terrified by the Greek crisis. Excluding that and the GFC, the $A is at its weakest point since late 2007 (in healthier times). There are a few differences here though – namely that the terms of trade is higher since then. Take a look at chart 2 below.

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Back in 2007 Australia’s terms of trade was a good 15% lower than it is now. At the very least that implies the currency should be 15% higher relatively, and indeed when you look at the chart above it suggests the Australian dollar is actually about 25% undervalued and has been undervalued all through the terms of trade boom. That equates to an Australian dollar well over parity with the $US, probably more like $1.10.

Also note that back in 2007, the cash rate differential between our central banks averaged 140 basis points in our favour. Currently, it’s about 250bp in our favour and that’s not to forget the fact that the  Federal Reserve Bank prints $US65 billion of money per month. That this is down from $US85 billion per month is really quite irrelevant for the currency markets from a practical perspective. It’s not like the Fed is draining $US out of the global financial system.  It is not even shrinking its balance sheet. It’s still growing.  

The outlook on rates

It’s with that in mind that rate expectations become important. In the US, no-one is looking for a rate hike until 2015, and that will be late 2015 by most counts.  Conversely, in Australia, expectations are building that the RBA will be forced to hike this year. Of the economists surveyed by Bloomberg, roughly 25% still look for one more rate cut at least this year, with just under half expecting no change, and the rest are looking for a hike. The market itself is pricing a 50% chance of a hike by year end. That’s a significant change from the 40% chance of a rate cut the market had priced in earlier this year.  In the end though the market abhors a vacuum, and given the early signs we are seeing of the economy responding to record low rates, I think it’s likely pricing for a hike will firm up.

Having said that, and as I’ve noted before, the actual path of monetary policy will take is extremely difficult to predict at this point. Not because of any ambiguity over the economic outlook mind you, but rather because of many unknowns with regard to how policy is being conducted. That is, the weights are given to the seemingly conflicting targets (exchange rate, inflation, property prices, and financial stability).

Government commitment

Much of the problem is political. People like Labor frontbencher Kim Carr, RBA board member Heather Ridout (who heads up the union movement’s largest super fund), John Edwards (a former ALP staffer) and the union movement in general, are all on record as stating that an exchange rate around the US80-85 cent market would be desirable. This is very much the manufacturing lobby’s viewpoint, and the previous government had a firm commitment to the target. What is less clear is how much of a commitment the current government has.

At the time of the latest RBA decision, the $A was travelling around US87.4 cents. It’s closer to US90 cents now than the US80-85 cents that so many want, so the question for investors is, does this concern the current government and the RBA board?

What if it moves to US92 cents? Given this opacity, neither I nor anyone else can truly have a firm idea where policy is headed. Which, by the way, largely explains why the market is so split on the direction of rates.

There’s also the question of how effective jawboning would be this time around anyway. Global and domestic economic indicators have turned sharply, so the incessant pessimism that helped drive down the $A in the past may not be so effective this time around.

To my mind, there is no question that without an actual lift in rates from the US or a large drop in the terms of trade – which is so far proving elusive – then the $A is significantly undervalued.

On balance then, and noting the above political difficulties with regard to policy, it is my expectation that the $A will continue to push higher this year, with a target of US95 cents easily achievable.

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.