Rising US dollar, slow China put Aussie on shaky ground

Although the Australian dollar has stabilised in recent days after heavy falls during May and June, the currency remains in a precarious position, threatened by the re-emergence of the US dollar and a slowdown in Chinese growth, analysts say.

Although the Australian dollar has stabilised in recent days after heavy falls during May and June, the currency remains in a precarious position, threatened by the re-emergence of the US dollar and a slowdown in Chinese growth, analysts say.

Speculation that the US Federal Reserve will reduce the flood of cheap money is helping to dampen the appeal of the Aussie because the cash available to invest in foreign assets such as Australian bonds will dwindle. Emerging bond funds already experienced a record $5.7 billion in outflows last week, according to EPFR Global.

"Who's going to be hurt from US tapering or a Chinese slowdown?" asked David Bloom, the global head of currency strategy at HSBC. "Which central bank is actively pushing its currency lower? Australia checks all of those boxes."

The Aussie tumbled 12 per cent last quarter as the nation's central bank cut interest rates, while the Fed said it could reduce the stimulus efforts that have supported global markets. Australia's 70 per cent reliance on foreign investors to finance its $257 billion national debt may indicate investors have already had their fill of its currency.

"The buyers of Aussie in the first quarter are probably experiencing a lot of buyer's regret at this point," Steven Englander, the head of Group of 10 currency strategy at Citigroup, said. "Investors bought some very expensive Aussie, and my guess is that they'll be looking to do some selling to unwind some purchases. They probably want to cut their allocation."

Last week, the International Monetary Fund released its debut report on reserve-manager holdings of the Australian dollar, which revealed that the currency may be vulnerable to quick outflows of capital that would jeopardise the nation's economy.

The IMF said global reserve managers such as central banks held the equivalent of $99 billion in the first quarter. The Australian government said last month foreign investors owned $206.8 billion of its sovereign securities.

"Australia is one of the most vulnerable countries in the developed world to a reversal in capital flows," said Alberto Gallo, the head of European macro credit research at Royal Bank of Scotland.

The Washington-based IMF specified official reserves of Australian and Canadian dollars for the first time in its June 28 report, after they'd previously been indistinguishable in the "other currencies" category. The RBA said in February that its currency was held by as many as 34 central banks.

Central banks had more than doubled holdings of the other- currencies category to $352 billion as of September 30, 2012, from $140 billion at the end of 2009. Reserve managers diversified away from the US dollar, yen and euro after policymakers in those jurisdictions cut benchmark interest rates towards zero or held them at that level.

Net foreign investment in Australian debt has exceeded outflows by $28 billion during the past three quarters after increasing $250 billion from 2008 to the middle of 2012.

The RBA has also put pressure on the Aussie by lowering the nation's benchmark lending rate to 2.75 per cent from 4.25 per cent at the beginning of 2012. At the same time, the economy of China, the nation's biggest trade partner, is throttling back with growth projected to decelerate to 7.7 per cent this year, the slowest pace since 1999, according to the median estimate of analysts surveyed by Bloomberg.

The Australian dollar's prospects for longer-term gains are threatened by a downturn in the carry trade, in which money is borrowed where interest rates are low to invest in countries offering higher yields. The Aussie has been a common purchase target in such trades, which drives strength in the currency when carry conditions are stable.

Deutsche Bank's G10 FX Carry Basket index fell 4.3 per cent in June, the biggest monthly decline since May 2012. The gauge is down 3.5 per cent this year.

The carry trade seemed like a sure bet for much of 2012 as weak economic data in the US, Japan and the euro region led to speculation among investors that central banks would keep rates low and money pouring in to boost growth. With those expectations waning, volatility is increasing, which is bad for the carry trade because it depends on predictable interest rates across jurisdictions.

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