Stevens’ murky dollar premonitions

The RBA governor drew a link this week between falling terms of trade and a lower dollar, but omitted a number of factors that could potentially push it higher.

Reserve Bank of Australia governor Glenn Stevens reckons the Australian dollar should fall.

Earlier this week, Stevens said that "these levels of the exchange rate are not supported by Australia's relative levels of costs and productivity. Moreover, the terms of trade are likely to fall, not rise, from here. So it seems quite likely that at some point in the future the Australian dollar will be materially lower."

“Materially” lower.

That is hard to quantify but it seems Stevens is reckoning the Aussie dollar should fall not a few cents, but a good 10 to 15 cents towards 80 US cents or so.

While I would not want to verbal the RBA governor, Stevens underplayed a range of other factors that drive the Australian dollar as he based his call on an expected drop on his forecast for the terms of trade. Stevens obviously knows that other factors influence currency markets which makes it a little odd that his focus on the terms of trade overwhelmed the other factors, many of which are likely to be supportive of an Australian dollar appreciation even if the terms of trade fall.

In other words, it would be reasonable to make the forecast for a lower Aussie dollar if commodity prices and the terms of trade fall and were the only variables that determined the value of the currency.

Many clever people have spent a lot of time working out the best way to assess whether the level of the Australian dollar is ‘fair value’ or not. Many different variables are identified and used to build the models for the currency.

Indeed, there is a strong understanding of the factors that actually do influence the value of the Aussie dollar. The problem with pinpointing a particular variable at a particular time is that the importance or weighting given to each determinant changes over time.

Sometimes the market judges the current account deficit to be important for the level of the Aussie dollar. Other times it is interest rate differentials and the carry trade. Other times it is the terms of trade, credit worthiness or growth. Other times, it is the economic performance and policy settings somewhere else in the world – China or the US, for example.

Which means that even if we take Stevens’ forecast for lower terms of trade over the medium term to be a given, what if the other drivers of the Aussie dollar turn favourable?

The dollar would not, in these circumstances, be materially lower and it could even be up.

It is not hard to see a scenario – in fact it is likely – that interest rate differentials between Australia and many other parts of the world will remain wide and could even widen further as the Reserve Bank moves to a rate hiking cycle in 2014. This should continue to support the dollar and might offset a terms of trade decline.

At the same time, Australia’s triple-A credit rating, near-perfect budget position and the positive sentiment this generates will see investors ready, willing and able to buy Australian assets, and with them the Australian dollar. With the rest of the world in a less robust position than Australia, this only exacerbates the positive sentiment towards the local currency. The super-easy monetary policy stance in the US is likely to keep the US dollar weak and, by definition, the Aussie dollar strong.

Stevens might be right – the dollar could fall a lot. If he is right, there will be a mighty boost to Australia’s competitive position and inflation will inevitably move higher.

If Stevens is wrong – and it seems more likely than not he will be – get set for the dollar to track above parity and for this to emerge as a thorn in the side of policy settings.

This is my last column for Business Spectator. May the economy remain strong, unemployment low and inflation well contained.

Cheers