Prepare for a dollar bounce

Given Washington's sequestration stance, central banks are unlikely to swap Australian for US dollars anytime soon. Add unwinding short positions and the Reserve Bank's mood, and the Aussie is set to rise.

The Australian dollar has devalued close to 5 per cent over the past two months, but local businesses struggling with the high exchange rate should not expect much more relief than that, and they certainly shouldn’t expect to be rescued by the Reserve Bank. In fact they should probably brace for a dollar bounce.

Cost-cutting – the dominant theme of this year’s interim profit season – will have to continue, and get deeper.

Reserve Bank documents released late last week under a Freedom of Information request from Bloomberg show that the central bank thought the currency was about 5 per cent overvalued when it was 5 per cent higher than it is now.

It was a note prepared for the September RBA board meeting, marked "confidential” and headed "Is the Australian Dollar Overvalued?” The answer: "The staff’s preferred model … suggests that the exchange rate is around 5 per cent overvalued”.

In August and September last year the dollar traded up to US105.8 cents. Since then the dollar has fallen to US102 cents and the iron ore spot price has rallied 70 per cent, so it’s unlikely that the Reserve Bank now thinks the dollar is overvalued.

The confidential RBA document also discussed last year’s intervention in foreign exchange markets by the central bank of Switzerland to stop the Swiss franc from rising, and concluded that the circumstances here are entirely different.

"There is not strong evidence that the Australian dollar is posing an imminent threat of deflation or is highly contractionary for the domestic economy. While those sectors of the Australian economy that are most exposed to external developments, such as manufacturing and tourism, have been adversely affected by the current high level of the Australian dollar, inflation is forecast to be within the target range over the next few years and the Australian economy is expected to grow at around 3 per cent over 2013 and 2014.”

Last week’s capital expenditure figures from the ABS show that while capex is weakening, the mining boom is not over. As a result, ANZ Bank’s foreign exchange strategist, Andrew Salter, expects structural shorts in the Australian dollar to be unwound.

"Expectations for mining investment, and indeed non-mining investment, are not falling off a cliff”.

While much of the Australian dollar’s strength is explaining by capital inflow for the mining boom, which will eventually end, it has also been the focus of a lot of central bank buying over recent years.

The Reserve Bank has examined 71 central banks’ forex reserves and concluded: "Our best guess is that … 16 currently hold AUD, 18 possibly hold AUD and 21 do not.” They couldn’t get enough information on the other 16 to make a guess.

Interestingly the central banks that do not hold the Aussie include the Federal Reserve, the European Central Bank, Bank of Japan, Bank of England and Bank of Canada.

The 34 that definitely or possibly do hold the unit control more than $US3 trillion in foreign exchange reserves, so only a small increase in the percentage held in Australian dollars, rather than US dollars, will have a dramatic impact on the value of the Australian currency.

And given the weekend events in Washington, they are unlikely to start selling Australian dollars and buying US dollars any time soon.

The failure of Republicans and the White House to reach a deal on the so-called 'sequester' budget cuts of $US1.1 trillion over ten years ($US85 billion in year one) is likely to keep the US unemployment rate above 6.5 per cent.

That’s the threshold for the Federal Reserve to keep printing money and buying bonds: Fed chairman Ben Bernanke has made it clear that 'quantitative easing' and 0-0.25 per cent interest rates will continue until the unemployment rate falls below 6.5 per cent.

The 'dumb' (according to President Obama) budget cuts that are now locked in will ensure that unemployment stays high for years, and will probably rise from here, which means that the Fed will probably redouble its efforts to debase the currency and keep them going for years.

In other words, 'sequestration' is likely to be positive for the Australian dollar.

Follow @AlanKohler on Twitter

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