The Australian dollar has now fallen nearly 6.5 per cent in only three weeks. Depending on your perspective, you can either blame or credit the US Federal Reserve board and hedge funds.
Since the financial crisis erupted in 2008, currencies have been driven by capital flows motivated by the monetary policies of the central banks of the major economies.
The Australian dollar has fluctuated, quite violently, since 2008, falling to a low of US65 cents in March 2009, hitting $US1.10 in mid-2011 and then dropping back below parity in May last year. Today it was trading below US88 cents.
The dollar has, since it bottomed out in 2009, traded at levels that have made the Reserve Bank increasingly uncomfortable even though, for much of the post-crisis period, its relative strength could be attributed to the impact of China’s economy on commodity prices and resource sector investment.
While the economic performance and fundamentals might have stood out compared with the state of the US, eurozone and Japanese economies, however, they probably haven’t been the key factor in the Australian dollar’s strength. The bigger influence would appear to be the capital flows.
The US Federal Reserve board responded to the financial crisis by dropping US official interest rates to near zero and embarking on the first of its quantitative easing programs. It was the second of the “QE” programs in late 2010 that appears to have been behind the surge in the Australian dollar through the first half of 2011. The third program, which started in September 2012, helped keep the dollar above parity.
It wasn’t until Ben Bernanke triggered the 'taper tantrum' in May last year by foreshadowing the start of the gradual winding back of QE3, and its $US85 billion a month of bond and mortgage buying, that the Australian dollar finally started to crack.
As this year has progressed the focus has been on the imminent ending of the program next month and speculation of when the Fed might start to actually raise US rates. The market has anticipated that the turning point for US rates could occur in the middle of next year, but more hawkish commentary from some Fed members has raised the possibility it could be reached earlier.
Markets move in anticipation of events, and so there has been a flow of funds into US dollar assets. US treasuries have been driven up as capital has flowed towards the US and the US dollar has appreciated markedly.
In effect that’s a reversal of what was occurring throughout most of the post-crisis period.
The flood of ultra-cheap liquidity the Fed pushed into the US system has been scouring the globe looking for positive returns. Emerging markets -- and Australia, with its solid yield differential over US fixed interest securities -- were major 'beneficiaries' of the flows.
Those flows are usually described as 'carry trades'. The hedge fund or some other risk-taking institution borrows within a low-interest environment to obtain a yield arbitrage in another jurisdiction. If a lot of institutions are pursuing the same trades, the currency in which they have borrowed will be pushed down and the currency in which they have invested will rise, as will the value of the assets they are acquiring.
There is, therefore, potentially a return from the yield play, a return from the currency play and a return from the impact on the underlying assets.
The carry trades have resulted in periodic bouts of volatility as the broader environment was seen to be 'risk off' or 'risk on' -- if the perceived risks rose, capital flooded back to the US -- but generally the past six years have seen them underpin the value of the Australian dollar.
The US dollar-funded trades were displaced to a significant degree after the election of Shinzo Abe as Japan’s Prime Minister in 2012 and Japan’s adoption of 'Abenomics', where the initial planks (or 'arrows') were negative interest rates and a massive stimulus program. The yen crashed and the program spawned a new source of funding for the carry trades.
Another source of carry trade funding has emerged more recently as the European Central Bank has responded to weak and weakening growth in the Eurozone with its own unconventional monetary programs. Since May the euro has depreciated by about 8 per cent against the US dollar.
The direction of the carry trades has reversed because not only are their positive rate differentials available in the US bond market but the end of the QE programs and the prospect of US rate increases was always going to mean a stronger currency, and the traders have been pre-empting -- and have brought forward that moment.
For those with leveraged exposures to the Australian dollar, the momentum that began showing up in the US dollar at the start of this month was a signal to head for the exits before the value of their exposures was hurt by the changing currency relativities. That has had a self-reinforcing and exaggerating influence over the rate at which the Australian dollar has fallen relative to its US counterpart.
The Reserve Bank, and Joe Hockey and exporters and trade-exposed sectors (but not importers or retailers who source offshore) will be pleased with the break in the dollar but hoping that it continues to develop and ease the acute pressure that the currency has exerted on the non-resource segments of the economy. They’d still see the dollar as being materially overvalued.
A dollar closer to US80 cents than US90 cents, if not a little lower, would also offer the RBA more flexibility to respond to a housing market it clearly believes is overheating and building a prospective threat to the wider economy.
It has kept the cash rate at a historically low level to reduce the appeal of the Australian dollar to the carry trade investors as much as it could.
A much weaker dollar would help free up its ability to bring monetary policy to bear on the housing market, or at least to fire a warning shot in the direction of prospective buyers entering the market with an expectation that today’s low-rate environment will persist.