Surveying the dollar's new strings

The key influences that broke the dollar's historic correlation with commodity prices are appearing to weaken, with the US and China set to determine a new level for the currency.

The most topical question in market circles at present is whether the Australian dollar has found a new level or whether it has started a slide back towards a more historical level against other major currencies.

The question is, of course, incapable of being answered without the benefit of hindsight but the balance of probabilities would tend to suggest that it might have further to go.

Whether or not it does is probably in the hands of the Federal Reserve board, the Chinese authorities and, perhaps to a lesser extent, the Reserve Bank.

After breaking through parity against the US dollar a fortnight ago the Australian dollar appears to have stabilised at just under US98 cents but there are analysts now arguing that it will continue to drift – or crash – down towards US90 cents over the next year or so, if not much lower. A fall to US90 cents over the next 12 months was, in fact, forecast by Goldman Sachs’ economics and strategy team on Friday.

The two major external influences that determine its path will be the US and China. It was rumblings about the Federal Reserve’s consideration of an earlier-than-anticipated tapering of its bond and mortgage-buying program – the QE III program that has seen the Fed buying $US85 billion of bonds and mortgages a month – that helped trigger the initial sharp fall in the value of the Australian dollar.

The Fed’s chairman, Ben Bernanke, will give his routine testimony before Congress on Wednesday, with some expectation that he might shed more light on the Fed’s thinking. With the key jobs market data in the US improving, some sort of recovery in the US housing market under way and its financial markets performing strongly, even some sense of optimism from Bernanke would be interpreted as bringing the end of QE III forward.

The influence of China’s economic condition is also a major factor in the future of the dollar, given that one of its attractions has been as a safe way of getting an exposure to China’s growth. With China’s economy appearing to be shifting into a slightly lower growth mode and the intensity of its consumption of commodities apparently dropping, one argument for buying the Australian dollar is weakening.

Indirectly, because of the impact of lower commodity prices on resources investment – the China-inspired decline has effectively truncated the investment pipeline – the slower rate of growth in its economy will also reduce the capital inflows funding investment that have supported the dollar’s strength over the past two years.

The Reserve Bank has played a role in pushing the dollar down. Its rate cuts, and most notably the most recent 25 basis point reduction which coincided with the speculation of an early Fed shift in stance, have narrowed the yield differential between Australian and US government bonds.

Bloomberg noted yesterday that the Australian 10-year bond yield premium hit its narrowest margin since November 2008 earlier this month and is still at its lowest level for nearly a year.

With a majority of currency traders betting on further Reserve Bank rate cuts, that margin could narrow further, undermining the appeal of the yield-driven trades that have seen foreign ownership of Commonwealth bonds soar to 70 per cent, although it is off the peak reached last year.

The Reserve Bank may not move further given that its previous cuts and the weakening of the Australian dollar will provide stimulus but, even if it doesn’t, as US rates rise in expectation of a Fed shift in policy the yield differential could be further compressed.

Japan, of course, is still printing money hand-over-fist so it is possible that there could be more support for the dollar from that direction but it does appear that some of the key influences that forced the dollar up and which broke its historic correlation with commodity prices are starting to weaken.

Unless the US economy falters or China responds to its lower growth trajectory with another massive injection of stimulus it is difficult to see why it would retrace a path to above-parity levels. There will be a lot of manufacturers and other-trade-exposed sectors hoping desperately that it doesn’t and, indeed, that it slides further.

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