Why our $US drop is done

Since a recent low in 2011, the $US index (which represents the US dollar against a basket of currencies – euro, yen, sterling among others) has appreciated by some 12% – a decent gain but perhaps still quite modest given all talk of a QE (quantitative easing) taper.

Now a lot rides on the direction of the $US, not least the Aussie equity market. At a very basic and direct level, its moves influence earnings per share growth of some of our largest stocks. Indeed, for the market as a whole, and while estimates vary, some strategists suggest that a 1 cent decline in the $A lifts EPS growth by 0.4%. Less directly, recent concerns over a new emerging market crisis are driven by $US movement (following growing taper talk) and of course the currency wars are, by and large, $US driven.

Similarly, it’s crucial in terms of pricing commodities and we can’t forget that its movements will also determine Australian monetary policy, given the RBA has adopted an unannounced exchange rate target. All of this is again is obviously key to the performance of Australian equities.

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The theory is that as the Fed tapers then the $US should rise. This makes sense; they print less money, there is notionally less $US floating around the market, and its price rises. This makes some analysts very excited in Australia because, the thought is, it means more EPS growth. That’s why there is a lot of interest as to how high the $US could get.

Looking at recent history, the high point over the last decade or so was a little over 100, but that high was achieved all the way back in 2003. For most of the decade though, the unit has traded between the low 70s and about 90 – range traded. At its current level of 82, and just on the charts, that implies some upside of about 10% from here – 22% in total from the low – which is in line with historical norms.

On a more fundamental level though, note that in each instance when the $US did hit its high, the market was being hit by some fear event. Risk aversion was high and investors sought the ‘safety’ of US dollar assets. So over the last five years for instance, the $US index has really only approached the top of the range (90) when there was some flare up in risk aversion. Chart 1 shows the GFC being one of these and the other was in June 2010. Recall back then the market was gripped with fear over Greece – Europe was on the verge of disintegration according to some, and safe have flows into the US were very strong as a result.

It helps, when thinking about global foreign exchange markets, to remember that the euro and $US are effectively a duopoly on the international trade and payments front; comprising 75% of all payments. You can’t have a discussion about one without having a discussion about the other. Indeed the weight of the euro in the US dollar index nears 60%. For interest, the Japanese yen is about 14% and UK sterling another 12% (all rounded up). So theoretically then, 60% of the movement in the $US comes down to the euro, although in reality it’s probably more than that as the US and Japan appear to have some bilateral agreement in their exchange rate with a target around 100.

Short-term considerations support of further $US strength

Why is all that important to remember? Because sentiment shifts between Europe and the US are critical in determining the bilateral exchange rate and the overall level of the $US index – and how cheap or otherwise the $A is.

In 2010, the talk of the town was a euro disintegration. Get out of euros, and back to the $US. In contrast, during the period from 2004-2008 it was the reverse – the euro put on one-third of its value versus the $US, rising from about 1.18 to 1.54 at its peak, in part because investors were becoming worried about the US current account deficit. To put that in perspective that would be like the $A rising from its current level to $US1.18.

A shrinking interest rate differential, from about the middle of 2006, was another key factor driving things. Chart two shows the US 10-year bond rate less the German equivalent, and that difference came down quite sharply from 117 basis points to about zero by late 2007.

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Fast forward to 2013 and if you look at both of these factors now – sentiment and the interest rate differential – both are strongly supportive of further $US appreciation. In fact, if anything the $US looks severely undervalued in this light. For now, the market retains lingering concerns over European debt – Greece needs a new bailout and sentiment then favours the $US.

And yet the $US index is up only 4% this year. Indeed with all of the above in mind, the remarkable thing is that the euro is still so strong – the $US not stronger. This perhaps shows the power of quantitative easing, and while Europe is conducting its own version, the Fed gets all the press.

But I suspect this also has to do with some of the medium-term factors which aren’t so supportive of the $US. You can see these in table 1. From the table, the US has a larger budget deficit, larger public debt and runs a current account deficit, all of which are negatives for the currency.

The US does have stronger growth, this is true, and it is leading the developed world recovery. But other nations aren’t far behind. The UK, for instance, is out of recession and the latest GDP figures show the economy growing at a reasonably solid 2.4% annualised pace.

With that in mind, positive sentiment to the US matters, sure, but as I’ve discussed, there is a limit to how far positive sentiment can drive things, given other countries are following and given the $US really comes into its own during times of strife. That is, the $US doesn’t usually hit its peaks because everyone is feeling warm and fuzzy on the US, but because they fear everywhere else – those metrics in table one perhaps explain why.  

So what does this all mean? Well, I suspect it means there is only limited upside to the $US from here (limited $A downside), maybe another 5%. The US is leading the developed world recovery; the Fed is leading the ‘tightening’ in rates, and that will provide near-term upside. But I don’t think we’ll see the peaks (around 90), given these peaks have only been in times of trouble. Beyond that, a strengthening elsewhere in the developed world could see sentiment turn and the $US even weaken. The Aussie dollar is likely to spend more time in the 90s than in the 80s, I suspect.

The outlook for equities

The implication for Aussie equities are that we can’t rely, in aggregate, on much more currency support, to the extent that it provided any. Key names that gained some favour among analysts – Amcor, Brambles, James Hardie and CSL – are going to have to provide more of a growth story than a currency story (I’ve discussed before that Bramble’s already does this) and maybe some favour will drop off these stocks on a six to 12 months view.

Luckily for our market, and looking more broadly, I think the prospect the $US rally may have limited upside could indeed provide that growth story, although more indirectly. How? Because it means that emerging market fears may not come to much, it means there will be limited downside to commodity prices, from a currency perspective, which is so important to our miners. A stronger $US and destabilised emerging markets would smash our miners.

It would also mean that prospects for the rest of the developed world were improving – again, another positive for Australia. In sum them, I think the $US will be a supporting force for the Aussie market, not because it's set to surge higher still, but because it isn’t.