Why the dollar will carry on

Macquarie has upped its forecast for the Aussie dollar, tipping it to reach $US1.10 by year’s end.

PORTFOLIO POINT: Macquarie has raised its forecast for the Aussie dollar, and now tips it to reach $US1.10 by the end of calendar 2012.

Which came first, the chicken or the egg? It's an old chestnut, but sufficiently relevant in the current context of Australian dollar strength. Under normal circumstances, a nation's currency, via its exchange rate with the US dollar global reserve currency, is a reflection of the relative strength or weakness of that nation's economy. But in the past couple of years, a stubbornly high Aussie exchange rate has acted as a drag on the Australian economy.

Historically, the Aussie dollar exchange rate has acted as a shock absorber on shifts in Australian economic fortunes. The 1997-98 Asian Crisis/Russian default/LTCM collapse period, the 2000-01 tech-wreck and 9/11 and the 2008-09 GFC all prompted big and rapid falls in the $A at a time when the Australian economy was much threatened.

On the flipside, in times when the Australian economy has been strong, a rising $A has provided a tightening effect sufficient to keep a bit of a lid on RBA rate hikes. That is, after all, the way it is meant to work.

It's not how it works right now, though. For decades, the $A has been viewed by the world as a “commodity currency”, tracking the rise and fall of commodity prices. But over the last 12 months, the $A has risen and commodity prices simply have not. China's economy has slowed and, by virtue of a new 7.5% GDP target, should slow further. All last year, the European crisis threatened to completely derail global risk appetite, and despite supposed resolution of Greece’s problems, opinions on Europe remain very much on the nervous side. Yet the Aussie remains as high as it's ever been post-float and can't seem to find any reason whatsoever to retreat. Why?

If we turn to foreign exchange 101, we learn that currency exchange rates are a simple reflection of global interest rate differentials. Something called “covered interest arbitrage” means that if you can borrow cheaply in one country and invest for a profit in another, risk-free, then the exchange rate between the two must adjust, so that by the time you convert your profits back into your home currency, they disappear. Otherwise you'd do it all day.

The problem is, forex 101 does rather live in that perfect world so popular with theoretical economists. One only need look at the persistent “yen carry trade” of the last decade to see that foreign exchange relationships are not quite as rapid-response as one might expect when gaps are huge and risk appetite is strong. For many years, Japanese pension funds could borrow yen at basically nothing and invest in Aussie bonds at up to 7% for a spread so wide the occasional shifts in exchange rate were not too much of a problem. Indeed, such carry trading acted to keep the gap open and stable as long as the buyers didn't desert. Every now and again they did, however, and for short periods losses were substantial.

Why are things different this time? Or are they? Macquarie's forex forecasters had earlier assumed the $A must come under pressure from a possible Greek default, a slowing China and further RBA rate cuts. They had set their end-2012 forecast level at a mere $US0.93. This morning (March 14) they raised that to $US1.10. And they don't see the $A falling below parity now until 2015.

Macquarie notes that foreign ownership of Aussie bonds is now around 75%. And the buyers have not only been Japanese pension funds and US pension funds, but other central banks and sovereign wealth funds. The current benchmark Aussie 10-year bond yield is around 4%. The equivalents in the US, Germany and the UK are all around 2%, and in Japan 1%. But that's the investment maturity. Compare short-term borrowing rates using central bank cash rates as a proxy and you have 4.25% versus zero, 1%, 0.5% and zero respectively. In other words, one can borrow short-term money offshore for next to nothing and invest in Aussie bonds at 4%. If all goes well, roll over and do it again. The risk is that the $A suddenly collapses and you are blown away on the exchange rate, but the more the world goes the same way, the more pressure there is on that gap to remain open.

In recent times, the $A has simply moved higher and stayed there. There's not a lot of incentive for US investors to buy BHP if the Aussie is already strong and may have more downside potential than upside. This becomes apparent when we look at the poor performance of the ASX 200 since last year's bottom, compared to the S&P 500. Although we do know that the mining services sector has been a runaway success story in that period. Why? Apart from the obvious driver of resource sector capex spend, resource service companies tend to be excellent dividend payers.

And that's where the foreign money has been going – into Australian yield, both bond and stock. Another reason why the $A has remained elevated. Move away from the financial markets per se, and Macquarie notes the Qatari sovereign wealth fund includes a food security division which has been busy buying up Australian farming operations.

Even if the Greek solution proves successful or Mario Draghi's presses keep the European crisis at bay, economists are assuming the US dollar must appreciate as the euro falls. Quite simply, the US economy is improving as Europe spirals into austerity-driven recession. A weaker euro to a stronger greenback would mean a stronger US dollar index, and one might assume a stronger greenback must imply a weaker Aussie. But the Aussie isn't actually in the US dollar index (pounds, yen, euros, Swiss francs, Swedish kroner, Canadian dollars) and besides which, the relationship between the euro and the greenback is separate to that of the greenback and the Aussie. So the US dollar index could fly high and the $A not move.

It's hard to see the $A falling any time soon, when Bernanke has promised as good as zero-cash rates out to 2014. Which goes a long way to explaining why Macquarie can't see any easing of $A pressure until 2015. That, and the fact we still sell everything to everyone in US dollars. And the Aussie against the euro is unlikely to fall while the ECB keeps up the cheap loans, nor against the pound or the yen while those central banks churn out the fresh banknotes as well.

The RBA could lower the cash rate a couple more times and not make a lot of difference. Only when the global tide turns will the Aussie turn, and that will require QE around the globe to end and a monetary policy tightening phase re-emerge to combat inflation risk. This assumes no hard landing in China, which seems to be less and less of a concern each month, and no further European disaster, the risk of which is lessened by money printing.

Macquarie still sees the Aussie back one day at a globally-balanced level of around US$0.80. But not until after 2015.

*This is an edited version of an article which first appeared on FN Arena.

Greg Peel writes for FN Arena, an online news and analysis service.

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