The reasons behind our dollar’s dazzling drop

The violent fall in the Australian dollar overnight has everything to do with US events, but it also reflects what’s happening in Europe, China and our own backyard.

The Australian dollar’s plunge below US86c appears to be due to an odd confluence of events, some of them related, that aren’t all good news for the Australian economy even if a lower dollar remains high on the Reserve Bank’s wish list.

The primary influence, of course, remains the direction of the US dollar. It has been strengthening as the indicators of growth in the US economy have become stronger: as the focus has shifted from last month’s ending of its massive quantitative easing program to the moment next year when the US Federal Reserve board finally starts to shift towards more conventional monetary policy settings, and as the continuing, indeed expanding, quantitative easing programs in the eurozone and Japan exacerbate the relativities.

The Republicans’ decisive victory in the US mid-term elections, giving them control of both chambers in the US Congress, and lower oil prices are also playing a part. Oil has been around its lowest level in about four years. Despite the remarkable shale gas revolution in the US, it is still a net energy importer.

With the eurozone struggling, Japan doubling up on its own long-running QE program, and US unemployment finally expected to dip below 6 per cent when Friday’s data is published, it isn’t surprising that the greenback has been strengthening.

There are, however, some factors that are more directly related to this economy that might help explain the violent move in the Australian dollar, which fell by nearly US2c overnight.

Iron ore and coal prices were already depressed but reports that China has ordered some of its steel mills to temporarily shut down (to reduce pollution levels ahead of the imminent APEC Summit in Beijing) have been cited as a factor in the latest slide in the iron ore price to $US76 a tonne, its lowest level in five years.

China, which links the renminbi to the US dollar, is also being impacted by the surge in the greenback at a time when the growth rate in its own economy has slowed sharply. That, too, doesn’t auger well for our commodity exports.

Nor does the fall in oil prices, although there was a slight pick-up today on rumours of an oil pipeline explosion in Saudi Arabia. Our LNG exports are sold at prices linked to the oil price.

It is no coincidence that the Canadian dollar, which also reflects the prospects of a resources-based economy, has also been hard hit.

The rise in the value of the US dollar does provide a partial offset against the impact of lower commodity prices, given that they are priced in US dollars, but it blunts rather than counters the declines.

The more positive news flowing from the US, the rise in the US dollar and the prospect that US official rates will begin rising next year have also undermined the carry trades that had supported the Australian dollar in recent years.

Where once it was attractive, in a “risk-on” environment, to borrow cheaply in the US and Japan to invest in Australian dollar-denominated assets to achieve both a positive yield arbitrage and the prospect of currency appreciation, it now makes more sense to borrow in yen and buy US dollar assets to deliver those outcomes.

Then there are, of course, the fundamentals. In his statement on monetary policy after this week’s Reserve Bank board meeting, Governor Glenn Stevens referred to “moderate” growth in the economy, with resource sector investment starting to fall away significantly but with some other areas of private demand expanding and growth expected to be below trend over the next several quarters.

He made his regular reference to the Australian dollar being above most estimates of its fundamental value (despite the already meaningful decline in its value) and offering less assistance towards achieving a more balanced economy than would normally be expected in the circumstances.

If sustained, the sharp fall in the dollar overnight would finally bring its value close to the mid-US80c range that many analysts believe would reflect more rational pricing.

There is, of course, the possibility that it might fall well below that level if the declines in commodity prices continue, which would have very mixed and not altogether positive implications for a domestic economy that has a very material resources tilt.