Why the Aussie dollar is strong as an ox

The Australian dollar is going from strength to strength after finishing just shy of a 28-year high on the trade weighted index. And bar a fallout from Europe or China, it's set to track higher.

Even with the banking and economic problems in the eurozone in general, and in Cyprus more particularly, the Australian dollar remains as strong as an ox. Or should that be as strong as a herd of oxen given it is just 0.6 per cent below a fresh 28 year high on the trade weighted index. 

Since February 1985, the Australian dollar TWI has not been above 79.3 points on the TWI and at 1600 AEDT yesterday, the Reserve Bank of Australia calculated the TWI to be 78.8 points with the Australian dollar 1.0364 against the US dollar. While the Australian dollar's level against the US dollar is well down on the peak last year at 1.1075, the fact that the US dollar has been strengthening on the back of the improving economic conditions in the US highlights the underlying resilience of the unit

At around 0700 AEDT this morning the Aussie dollar was trading at 1.0395, gaining a little ground against a resilient US dollar. If it stays near this level throughout today, when the Reserve Bank calculates the TWI at 4.00 pm it will be very near 79.3 points and therefore at a fresh 28-year high. 

Reasons for the Australian dollar's resilience and outright strength remain relatively easy to identify. 

It seems unlikely that the RBA will be cutting interest rates again in this cycle, which will keep a wide interest rate gap in Australia’s favour over the likes of the US, Japan, most of the eurozone, the UK and Canada. At the same time, retail sales are picking up, house prices are strengthening, the surge in wealth from the recent gains in share prices is boosting consumer sentiment and the jobs market is consolidating with job ads rising and the unemployment rate steady. 

At the same time, international investors and ratings agencies having nothing but praise for the fiscal management of the economy over the past few decades. Even now, in the aftermath of the financial crisis, government debt levels are trivial and the decision not to blindly pursue a budget surplus in the current fiscal year has drawn wide praise. As things stand, it looks like the budget will be in surplus in 2013-14. 

The triple-A assessment of Australia’s economy and fiscal position is a magnet for investors as they weigh up the credit risks with other countries around the world. 

Another factor behind the Australian dollar's strength is the news of a pick-up in the global economy. The US is poised to record GDP growth above 3 per cent for the first time in six years while China is humming along with 8 per cent GDP growth. Despite this better news, commodity prices have been flat in aggregate, even though there have been some big moves in individual commodities such as iron ore and gold. 

At the start of the year, I was speculating that the Australian dollar could rise to $US1.20 or even $US1.25 against the US dollar over the next couple of years (How high can the Aussie dollar go?, January 8). 

A very strong Australian dollar still looks likely over the next year or two, but rather than the strength necessarily being focused against the US dollar, it is likely to be strong against most currencies and hence the TWI. One issue that I didn’t fully anticipate was the risk of a stronger US dollar as the US economy recovers. 

Perhaps the forecast for a stronger Aussie dollar should be a call for a 10-15 per cent rise of the on a trade weighted basis. That is, the Australian dollar's strength against the British pound, Japanese yen, euro, Canadian dollar and Indian rupee and perhaps holding ground against the Chinese yuan. 

This looks more likely than a straight line move to $US1.20 or more. 

So what can go wrong with this view? 

The biggest risks remains global. An unexpected slump in Chinese growth or market turmoil from a serious banking or sovereign debt issue within Europe would clearly be bearish for the Australian dollar

Domestically, there does not seem to be much that can go horribly wrong. To be sure, the election of September 14 could throw up the risk of policies that scare global investors and pull the rug out from under the Australian dollar. Issues concerning the government debt ceiling or unnecessary fiscal austerity are two that spring to mind. 

There is also a risk that stronger global growth provides investment opportunities outside Australia, in the currently battered and bruised economies of the world and that at some stage, investors sell their profitable Australian dollar investments to buy cheap assets elsewhere. 

For now, the Australian dollar remains in vogue. It is strong, it is a higher yielder backed by some of the best macroeconomic fundamentals in the world. Who wouldn’t want some Australian based investments? 

It looks like the local currency will remain stronger for longer. 

Too see the weights and methodology used by the Reserve Bank of Australia to calculate the TWI, click here.

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