The RBA's dollar dreams might come true

The RBA's jawboning failed to move the stubbornly high dollar, but conditions in the US appear to be having a bigger impact.

With the Australian dollar now trading below US91c, is Glenn Stevens finally going to get what he’s long wished for?

For some years now the Reserve Bank and its governor have made it very clear that they think the Australian dollar has been significantly overvalued. They have tried, without much success, to talk it down at every available opportunity to ease the pressure on the non-resource sectors of the economy and facilitate the necessary rebalancing of activity as the resource investment boom subsides.

Only a little over two months ago the dollar was trading around US95c. Yet in the space of about a week it has cracked, tumbling from US94c to just below US91c.

While the decline probably has more to do with US dollar strength than Australian dollar weakness -- the US dollar has strengthened against all the major currencies -- the continuing dive in iron ore prices is a reminder of the traditional correlation between commodity prices and the dollar. (Last night, the spot price fell below $US82 a tonne.)

The major factor affecting currencies, however, is undoubtedly driven by the continuing recovery in the US economy and its implications for US interest rates -- and therefore for the appeal of holding US dollar assets relative to those elsewhere.

Until recently, near-zero official interest rates in the US, Europe and Japan and the still historically high levels of some key commodities made the Australian dollar and the relatively high yields available an attractive play.

At the margin, lower commodity prices and a sluggish economy ought to lessen the attraction. No one has taken yesterday’s odd unemployment numbers seriously.

The big issue driving capital flows at present, however, is the outlook for US interest rates and the current reality, which has seen short term market rates rise.

Next month the US Federal Reserve board will finally end its program of bond and mortgage buying, bringing to an end a policy of quantitative easing that has expanded the Fed’s balance sheet by about $US3.5 trillion since the Fed embarked on its experiment with unconventional monetary policies in 2008.

As that moment has loomed closer, speculation about when the US will finally start to raise rates has intensified. A research paper produced by the San Francisco Fed this week, which suggested investors were under-estimating the Fed’s willingness to raise rates, produced a spike in bond yields.

Most of the speculation about the timing of a shift in US official rates has focused on the middle of next year. The markets may now be moving in anticipation of that shift, or even factoring in a slightly earlier move.

In any event, gaining US dollar exposures ahead of the change is an obvious strategy, particularly given the weak and weakening states of the eurozone and Japanese economies and the faltering condition of China’s economy, as well as concerns about its financial sector.

Given that none of the trends underlying the shift in currency relativities is likely to reverse any time soon, it would appear likely that the US dollar will continue to strengthen. Europe has just embarked on some unconventional monetary policies of its own as its key economies have turned down, Japan’s economy shrunk in the June quarter and China is grappling with slowing growth and structural issues.

In the absence of an unexpectedly sharp lift in Australia’s economic growth rate and a consequent rise in Australian interest rates, the Australian dollar might well fall further towards the mid-US80c level the RBA believes would reflect more rational pricing. Glenn Stevens would have gotten what he wished for.