Peak to trough, the Australian dollar is down about 10 per cent over the past year or so, the bulk of that fall occurring over the second half of September. Now as everyone is aware, the RBA, Treasury and a variety of economists have been gunning for a weaker currency for about three years. I don’t think it’s unreasonable to state that the RBA has effectively had an exchange rate target over that period. Unfortunately I think they’ve bungled it though and consequently I’ve had to revise my view that the Aussie would head toward 85 cents, on a sustained basis, over the medium term.
Indeed on current metrics, the Aussie dollar is looking very cheap and against Euro and Yen, our weaker currency makes absolutely no sense at all. Don’t forget that the recent weakness in the AUD has had very little to do with Aussie-specific factors. It’s all about the US dollar and the Fed.
The thing is, and as I noted last month, once the Fed starts hiking, other central banks, including our own RBA, won’t be too far behind. If the USD is rallying on expectations the Fed will hike, then that trade will unwind as the BoE, ECB and the RBA start hiking also.
That’s not to forget what will happen if the Fed doesn’t end up lifting rates for a lot longer than the market currently thinks. Not an unlikely event given their track record.
Either way what does that leave us with?
A yield advantage that is simply too good to pass up for international investors, that’s what. 10-year bond spreads to the US have compressed some, fair to say, yet there isn’t a perfect correlation between spreads and the AUD – so that doesn’t necessarily mean much.
In any case, spreads remain well and truly in Australia’s favor (around 100bp) and at the shorter end, cash spreads have actually widened slightly over the past year. In a yield hungry world this matters a lot.
Over on the terms of trade front, the 21 per cent decline that we’ve seen since the peak, is often cited as a reason why we should expect the Aussie dollar to be markedly weaker.
This is not true. Despite that 21 per cent decline, the terms of trade is actually still about 35 per cent above the post-float average. Surely that implies the currency ought to be well and truly above its average also? It would be inconsistent to suggest otherwise – like our policy makers do.
No, the simple truth is that the terms of trade actually points to an Aussie dollar that is very much undervalued: an assessment that’s consistent with a number of other indicators too, I might add.
Perhaps of most interest, the Economist’s Big Mac index had the AUD at fair value at 94 cents. That suggests a 7 per cent undervaluation now. Then of course the current account deficit is much narrower now than it has been historically. This also implies, at least on the theory, an undervalued currency. It’s half what it was back when the AUD last held around the 80 cent mark!
Of course, fundamental models of exchange rate determination don’t generally work very well. Sentiment plays the key role and that’s a complicated beast to measure. The government and our key bureaucrats are doing their utmost to destroy confidence, this is true – but trying to get a sense of sentiment can be tricky.
Naturally enough, that the currency has slumped suggests sentiment is bearish! No prizes for that statement. Yet how bearish? This is where some of the technical indicators come in, and on even some of the more basic indicators, the Aussie dollar is, once again, very much oversold.
Chart 1: AUD is very much oversold
Take a look at Chart 1. It shows the AUD spot rate and then beneath that the relative strength index (RSI) -- and it shows the AUD well and truly in oversold territory (the green line). That’s still the case even after last night’s 40pips jump.
As a final point, that the currency dropped so suddenly without much in the way of a catalyst should be a further sign that this sell-off rests on weak foundations.
My own view is that, purely on the economics, the Aussie dollar should be well over 90 cents and even something around parity wouldn’t be out of order. Whether we get there or not is a difficult call and that’s because central banking is now less concerned with economics and national welfare and more about politics and game playing. Central banks have constantly warned market players that they are too complacent -- and that measures of volatility did not reflect the risks. I suspect they’ll show us exactly why that is the case over the next 12 months.