Aussie Dollar: Just how low can it go against the greenback?

Currency markets are among the most exciting in the world. Somewhere, someone is always trading a currency.

The market only ‘sleeps’ for a few hours a week after the west coast of America shuts down on a Friday night, and before New Zealand opens for business early on a Monday morning. The market is fast-paced, competitive and requires participants to assess and judge developing stories with a high degree of accuracy.

Despite the Australian economy’s relatively small size, the Aussie dollar is one of the most highly traded currencies in the world. Its popularity feeds on itself as well – that is, the more it’s used, the more liquid it becomes, and therefore the more attractive it is as a tradeable currency.

The Aussie dollar has also become quite an intricate asset. Indeed valuing it has become somewhat of an art. I’m now going to show you though how to forecast its movements.

I can’t tell you how to value it (determine its price) – I’ll leave that to the chief currency strategist at one of the major banks. And indeed you don’t need to know its value to participate in the market. You do need, however, to know its next move.

I developed the model I’m going to pass on to you in the dealing rooms of the Commonwealth Bank, CMC Markets, and through my own forex trading.

To determine the direction of the Australian dollar, or to forecast its next move, consider the following nine criteria:

- Federal Reserve’s interest rate policy
- Bank of Japan’s interest rate policy
- The Reserve Bank of Australia’s interest rate policy
- The outlook for the Chinese economy
- Australia’s unemployment rate (inflation rate)
- Global economic sentiment (levels of risk appetite)
- Geopolitical developments
- The price of gold

- The general health of the Australian economy

This list is basically in order of importance. The factors at the top are the most crucial for the dollar, while the factors at the bottom are less important. Certainly the factors at the top of the list will more likely explain significant moves in the currency.

So let’s take a look at the main risks facing the dollar right now. And be careful, most people associate the word “risk” with something negative. In markets it simply refers to the likely direction of an asset. So analysts will often talk about upside and downside “risks” – simply referring to the factors that will contribute to an asset moving to the upside or downside.

US interest rates

This is the Holy Grail for Aussie dollar trading. Here it is in a nutshell: the Australian dollar is perhaps most sensitive now to US interest rates (specifically the US Federal Funds rate). When it rises, and it will eventually have to lift, the Australian dollar will fall significantly.

We know this because even the suggestion of a possible lift in interest rates by the Federal Reserve has been known to take the wind out of the Aussie’s sails.

The reason for the relationship is simple. Investors park assets in countries with the highest yield. If the choice is between Australia and the US, you would pick Australia.

In the US you effectively get zero per cent return for your money, while in Australia, the base rate is 2.5 per cent.

The demand for Aussie dollars will therefore fall if that difference between rates is reduced. Put more simply, if US rates start to rise, suddenly owning US dollars begins to look more attractive. That logically means that the currency pair AUD/USD would naturally change in composition.

Japanese interest rates

Welcome to the “carry trade’’. This involves borrowing in one country’s currency, and investing that money (after exchanging it) in another country’s banking system or debt markets. With Australian interest rates relatively high (on the global stage) and certainly higher than Japanese interest rates, the carry trade makes a lot of sense right now and is seeing significant demand for Australian dollars by investors looking to hand over their yen in exchange for Aussie dollars.

Moves by the RBA

Of course the Reserve Bank board has the power to influence the demand for the Australian dollar by lifting or lowering interest rates. Obviously if the bank were to lift rates at the moment the Aussie dollar would rise.

The reason for putting this factor lower on the list is that the RBA has both limited fire power, and is currently a little boxed in to its “on hold” stance. For instance, if governor Glenn Stevens decided he wanted to cut the cash rate to bring down the dollar, he would face the possibility of producing a surge in housing prices.

In addition, with the dollar also buying less for imported goods, imported inflation would then work against the decision.

China

The relationship here is simple. The better the Chinese economy does, the stronger the Aussie dollar is likely to be. Many analysts though are confused as to why the Aussie dollar falls when robust Chinese export numbers are released.

The reason is that while strong exports are good for the Chinese economy (and will support the dollar), currency traders are more interested to know what the Chinese appetite for imports is – especially Australian imports. This was the case last week.

The export number was strong, but the import number was relatively weak – so the dollar fell.

Australian jobs

Last week’s unemployment rate reading demonstrated this relationship nicely. Australia’s unemployment rate spiked to 6.4 per cent and that sent the dollar down around 0.5 US cents. The logic here being that now there is more chance the RBA will be forced to lower interest rates further to cushion the economy that’s in a re-balancing phase.

Other factors

There are of course other factors that go in to determining the direction or value of the dollar. The most notable of these is probably global risk appetite or sentiment.

This can be influenced by major economic events or by geopolitical events. Rising tensions between Europe, Russia, and the United States for instance would certainly influence global risk appetite. The basic rule is that demand for the Australian dollar will rise if global risk appetite is strong.

Who really controls the market?

Individual currencies move when major financial institutions or hedge funds take a significant position in one currency or another. Currencies will also shift based on the buying and selling activities of the Federal Reserve, the People’s Bank of China and the Bank of Japan.

The Bank of England also has some firepower. Currency markets are not moved by mums and dads, or buy lots of people going to currency exchange bureaus at the airport!

Forecast

Based on the model above, my own conclusion is that the risks to the Australian dollar are to the downside – meaning I think it will trend down over the coming months/years.

They key factor for the Aussie right now is any movement in US interest rates. This is a tricky one. I don’t believe the US economy is ready for a tightening of monetary policy, but I also know that jobs growth is emerging as a potential problem for the Federal Reserve.

It’s a problem because a disproportionate amount of Americans are still out of work (and not looking for work either).

They are out of the statistics altogether and on food stamps. They represent the America that is still in recession.

There’s also been a surge in those who are part of the statistics and have been looking for work and have found a job.

That jobs growth has the potential to put upwards pressure on wages and domestic demand as a whole (and lift inflation). So yes the US Fed could lift rates but it would risk choking off the recovery (as much of America still struggles). That said, its hand may be forced as the ‘’official measure’’ of unemployment continues to fall.

A conservative estimate would be that the Federal Reserve starts to lift rates early next year. That would see the dollar move down to between 85 and 90 US cents.

If the Reserve Bank lowers the official cash rate at the same time, the dollar would probably move down below 85 US cents.

Two other important influences at the moment are the unemployment rate and China’s economy. I suspect both will deteriorate somewhat in the coming months which would also put downwards pressure on the dollar.

US interest rates are stable at present though, and global risk appetite is reasonably robust, so the dollar (barring a near term shock) is likely to stay range bound in the near term. That means somewhere between 91.5 US cents and 93.5 cents.

So it’s still happy days for Australian consumers buying overseas products and Australian importers that are enjoying wider profit margins.

Tourists travelling overseas will also be better off for at least the next little while.

Unfortunately exporters, local tourism operators and higher education institutions will continue to feel the pinch.

I’ve been told by many analysts and industry spokespeople that a comfortable level for the dollar – for them – is on or under around 85 US cents. That’s likely to come, but maybe not until next year.