Aussie dollar could fall spectacularly, on a dime

 

I’m constantly looking at financial markets commentary. I may be a little biased in saying this, but I’ve noticed recently that writing about every movement in the Aussie dollar, and predicting where it may move, seems to be a national past time.

I can see where the interest is coming from: a significant movement one way or the other in the currency can affect your plans. It can make travelling more or less expensive, it can turn a business profit into a loss, and a weak currency can cushion the blow of collapsing economy.

So where to then for the Australian dollar?

I’m going to outline where you can expect the dollar to move over the next 6 months. Hopefully it’ll give you a better idea of how the currency is placed rather than relying on day-to-day commentary that seems to regularly contradict itself.

Also read: Will the ASX follow Wall Street to record highs?

I’m also going to chicken out with my forecast and give you two likely scenarios, rather than one.

I’m also not going to tell you what I think until the end of the column. You’ll have to read to the end, or go straight to it!

An asset

The Australian dollar is just like any other asset. It holds value, and that value can be analysed. There are a few strong forces holding the Australian dollar in the range it’s found itself in now, and a few minor forces pulling it here and there.

So let’s break it down.

Interest rates

By far and away the biggest factor affecting the Australian dollar, against the US dollar, is the interest rate differential between the two countries.

It’s for obvious reasons too. Traders and investors chase “yield” or a “return” on investment. An interest rate is a return on money held in deposit. So if you’re able to borrow money in a low interest rate environment, and invest it in a higher interest rate environment, of course you would – especially if you don’t even need to borrow the money to invest or deposit it.

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So long as Australia’s official cash rate stays materially higher than the US Fed Funds rate, Australian deposits will look more attractive, and foreign investors will buy Australian dollars in order to take advantage of that “yield differential”.

That’s why we all go so bananas over an RBA interest rate decision or anything that comes out of Federal Reserve chairwoman Janet Yellen’s mouth... because it ultimately has a direct affect on the Australian dollar.

Economy

Economic data plays a big role in moving the Australian dollar too. Much of it though is indirect – meaning that better economic news points to the likelihood of a rate rise in the near term, while poor economic news points to a rate cut.

For instance last Thursday, despite official figures showing a fall in Australia’s unemployment rate, the number of full time jobs actually fell by over 50,000 in the month of September. That was the biggest monthly decline in over 5 years. It was seen as a weak jobs report and the Australian dollar fell both in Asian trade, and then again in European and North American trade too.

Another crucial data point is inflation or the Consumer Price Index (CPI). People’s eyes glaze over with this one. I’m not sure why because I sure as heck would like to know if the cost of living is going up – might prompt me to ask for a pay rise!

Central banks around the world, including Australia’s Reserve Bank, actually target a level of inflation. In the RBA’s case it’s for a CPI of between 2 and 3 per cent. That’s considered to be a “goldilocks” range for inflation, which keeps the economy humming along nicely.

This week, the official quarterly inflation figures were subdued, but probably not enough to prompt the Reserve Bank to cut interest rates on Melbourne Cup Day.

Interestingly though, a big contributor to the increase in prices was a near 20 per cent increase in fruit prices caused by bad weather.That most likely won’t be repeated.

You can’t argue with the numbers though, so based on this latest data, you’d likely conclude that the Reserve Bank will stay on the sidelines at its November meeting. Naturally, this have given the Aussie dollar a nice little tailwind recently.

 

Also read: Western Australia's economic future remains uncertain after the mining boom

Commodities prices

The Australian dollar is a commodities currency. That means the dollar generally appreciates when commodities prices (oil, iron ore, coal) rise in value.

Australia is a resource-rich country, so naturally as commodities prices rise and fall, so does Australia’s overall ‘worth’, and the currency responds to that.

Recently we’ve seen strong rises in oil and iron ore. Oil rose off the back of the possibility of OPEC cutting production back, and the pick-up in the price of iron ore is likely related to the ramp-up in steel production from China. China is meant to be cutting back on steel production as part of its reform agenda to transition to a more consumer-based economy – but that ain’t happening obviously. The world’s second largest economy is also risking a rather large commodities crunch in the medium term (China has a debt to GDP ratio of around 250 per cent).

Geo-political

Of course overseas politics plays a part in the value of the dollar too. To name just a few: Brexit, the US election, developments in the South China Sea, and the central bank policy decisions of the European Central Bank, the Bank of England, and the Bank of Japan; they all influence the dollar.

Risk appetite

What is “risk appetite” you ask? Put really simply it’s how hungry investors are to take a gamble on something. If the economy and the markets are buoyant, people tend to jump in the market to make a quick buck. The aftermath of any financial crisis is at the opposite end of the spectrum.

Generally speaking, the ‘happier’ investors are around the world, the more likely it is that the Australian dollar will rise in value, and the opposite is true.

Also read: Why bad Aussie job numbers don't have me worried

DT’s forecast

So wrapping it all up, right now, investors are ‘happy’. The Australian economy is humming along, the US Federal Reserve hasn’t yet raised interest rates again, China has an annual growth rate above 6.5 per cent, commodities prices are rallying, and geo-politically, we’re not on tenterhooks.

That might help to explain why the Australian dollar has found itself in quite a solid “technical” range between 74.5 and 77.5 US cents.

That’s a relatively high exchange rate given the headwinds facing the Australian economy, but the economy is in fact holding up. Or as a contact of mine at Westpac, Sean Callow, recently put it, “the speculative market seems to have already priced in fair bit of good news for AUD.”

However, and that’s a big “however”, all the points mentioned above could turn around very quickly. China’s currently embarking on an unsustainable debt binge, the US will need to raise rates at some point, and commodities prices (along with risk appetite) will likely turn down on the back of all that. Some of the major growth forces driving the Australian economy too (property bubble), are also precarious at best.

For me, the “risks” to the Australian dollar are to the downside. It may well get as high as 78 or even 79 US cents in the short term, but I suspect it will be between 70 and 75 US cents early next year, and possibly even lower by mid-2017. Longer-term, if the Australian economy hits the skids – as one or two economists are predicting – the dollar could and should fall into the 50s to cushion the slump.

 

Disclosure: the writer currently has a short position in the Australian dollar

David Taylor is a journalist with the ABC. Before taking up a position with the ABC, David was a financial markets analyst and economics commentator. You can follow him on Twitter: @DavidTaylorABC.