Watch out below! The Aussie dollar is about to sink

Watch out below! The Australian dollar is on the cusp of a significant fall. Already in recent weeks it has slumped from about 81 US cents to around 76 US cents at present and the factors that generally hold sway over the direction of the Aussie dollar suggest more falls are in store.

Commodity prices are going nowhere. The days of US$150 a tonne iron ore and massive prices for coal are well past. While the week-to- week changes in commodity prices can appear extreme, they are in a range a good 40 to 60 per cent lower than the peak levels around 5 years ago when the dollar traded as high as 1.10 against the US dollar.

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Also keeping commodity prices lower is the fact that miners have slashed the cost of digging these commodities out of the ground. They can sell their output at a lower price and still have a healthy profit, because of this cost cutting.

At the same time, the tens of billions of dollars invested by the mining sector over the past decade have build what are now fully functioning mines, adding to the supply of bulk commodities in the world market. While demand is still strong, the fact that output (supply) has run faster and cost of production has fallen, it means the overall level of commodity prices is broadly flat.

The big issue rapidly unfolding for the Aussie dollar is the erosion of the gap between global interest rates and those prevailing in Australia.

Against the US, the interest rate gap is effectively zero. If the US Federal Reserve continues to hike its interest rates and unwind its quantitative easing, while at the same time the RBA leaves rates on hold – or even cuts as Australian economy remains mired in a low wage/ low inflation funk – it wont be long before US interest rates will be materially above those of Australia.

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When this happens, the Aussie dollar will lose a lot of attraction to foreign investors. A money manager in Tokyo or Frankfurt or London or in the Middle East will have little reason to buy Australian dollars. Indeed, it could even result in those fund managers selling Aussie dollars and switch into US dollars.

Also importantly, the interest rate cycle in a number of Australia’s competitors for investment funds, the UK and Canada, have started their interest rate hiking cycles. The gap between interest rates in those countries and Australia is also falling and this has seen the British pound and Canadian dollars rise sharply against the Aussie dollar over the past few months

Then there is the difficult to measure political risk.

With the Australian government lurching from crisis to crisis and economic policy making on the back burner, confidence about Australia’s economic place in the world is being undermined.

The economists at the Royal Bank of Canada have been noting these political risks, and the prospect of an early election as a reason for investors to be cautious about investing in Australia. While a major policy upheaval is unlikely to show up, the risk is real.

In the end, it is not fanciful to think the AUD will break below 70 US cents early in 2018 and if we see three or four rates increases in the US and steady to lower interest rates in Australia, both of which look likely.

By this time next year, or even sooner, the AUD could be floundering under 65 US cents.