Aussie dollar is on thin ice

 

On the 8^th of February, 1999, the Australian dollar was trading at 65.25 US cents. Gross Domestic Product (GDP) in that year was rocketing along at 5 per cent.

Just 2.5 years later and, after the worst of the tech bust had passed and 9/11 was still a very raw memory, Australia’s GDP had slipped to 1.9 per cent, and the dollar was trading at 48.33 US cents.

The latest annualised GDP data has the Australian economy growing at just 1.8 per cent.

Also read: Aussie economy downcast while the US is set to surge

Now, I’ll admit, I’m dangerously close to comparing apples with oranges here (in terms comparing and contrasting GDP data and the value of the dollar over the years), but I do want to make this point: the Australian dollar is holding onto its current value on the thinnest of margins.

The economy now, as it was in the early 2000s, is sluggish. The difference between then and now is a huge, unexpected surge in the price of iron ore. In fact iron ore was trading under $US20 back then.

A senior currency trader from a major bank told me last week that, absent the huge 120 per cent rise in the price of iron ore this year, and the Australian dollar could be between 45 and 55 US cents.

Now while I don’t believe the Australian dollar could have a 4 in front of it, there’s a lot of room for it to fall.

Let me briefly outline why.

Also read: Five things to watch in Aussie stocks

Interest rates

Really simply, relatively high interest rates in any given country act like a magnet for foreign money (capital). Over the past few years, Australia’s interest rate “magnet” has been attracting a lot of capital.

When compared to the United States, for example, Australian term deposits look quite attractive. In fact, why not borrow from the United States, and invest that money in Australia? That’s called a “carry trade”, and it can be quite lucrative with vast sums of money.

Something unexpected happened last week however. The Chairwoman of the US Federal Reserve, Janet Yellen, told the world that after raising interest rates in December, the central bank would look to raise interest again as many as three times in 2017.

Now that wouldn’t normally raise any eyebrows Down Under, except for the fact that the Reserve Bank of Australai, at this point, doesn’t look like it’ll be moving the official cash rate off the historically low level of 1.5 per cent for the foreseeable future.

The more US interest rates diverge from Australian interest rates, the more downward pressure there will be on the AUD.

Commodities prices

The outlook for Commodities prices, and indeed the stock values of some of Australia’s biggest miners, was looking a bit grim this time last year. What a difference a year can make. The prices of some of the nation’s key commodities: iron ore and coal, have performed a miraculous turnaround. In fact, the price of iron ore has rocketed up around 120 per cent.

It’s virtually impossible to attribute this rise to a single factor. It’s my understanding that several factors are at play. They include: Chinese government stimulus measures, supply disruptions to the steel industry (to curb pollution), and bullish speculation in the iron ore futures market – which can influence the spot or ‘real’ market.

Also read: 3 investments to avoid in 2017

If the prices for commodities were going to rise from here, or even hold, I’d say the Australian dollar’s going to be “range bound” for a while. But I don’t think that’s the case at all. Neither does the Australian government.

According to Treasury documents, the price of iron ore is set to drop around 30 per cent from current levels by the middle of next year.

Iron ore has already risen from lows of around $US38 a tonne in February to a two-year high of $US82.80 a tonne this month. The commodity is obviously subject to a lot of volatility and I suspect it will come hurtling back to earth early next year.

The worst forecast for commodities prices would see the Australian dollar fall into the low 60s, and possibly into the 50s as well.

Also read: Is low Aussie inflation a bonus or a burden?

Economy

Earlier this week we were informed – via the platform of MYEFO (Mid-Year Economic and Fiscal Outlook), that the Federal Budget Deficit will increase by $10 billion. That’s billion, not million. Part of the problem – apart from an expected drop in commodities prices – is that wages are growing at a snail’s pace, which is obviously affecting tax receipts. The government must keep spending as well, despite the drop-off in revenue.

I’m told economic growth in 2017 will be patchy at best. That means that when we do hit those big economic ‘pot-holes’, the ability of policy makers (which includes the government) to rev-up the economy again will be diminished – especially considering interest rates are already at historic lows and the housing markets in Sydney and Melbourne are already grossly overvalued.

The currency of any country is a mirror image of the health of the country’s economy. Just look at the Mexican Peso, as an extreme example. It’s easy then to see why if the economy only sputters along next year, the dollar will find it very difficult to hold its ground.

Moreover if Australia loses its AAA credit rating, that will also be a cue for traders to sell the currency.

Risk appetite

2016 saw what’s been dubbed the “Trump rally”. It’s the unbridled enthusiasm shown by investors who believe president-elect Donald Trump will usher in a new generation of economic growth in the United States.

If that proves correct, given the US is the world’s biggest economy, I suspect global investor risk appetite could keep rising. That is, traders will be more and more willing to take big, positive bets on the market. That would put upwards pressure on the Australian dollar, because the currency is often seen as a barometer for investor enthusiasm right around the world.

At the same time, it would also encourage buying in the greenback (the US dollar), and that would obviously put downwards pressure on the Aussie.

Ultimately I think “risk appetite” will be neutral for the Australian dollar.

Also read: Why the Aussie dollar is even stronger than you might think

That ain’t gonna happen!

If I had a dollar for every person who told me this year, “that ain’t gonna happen”, I’d be very wealthy. Whether it was Brexit, or Donald Trump, or Brangelina breaking up… no doubt about it, 2016 was the year of “come again?”.

The Australian dollar could fall into the 50s against the greenback. I doubt it will fall in the near term, but I wouldn’t be surprised to see a 5 or 6 in front of it by mid next year. Far more seemingly unexpected and dramatic events have happened in the past 12 months.

Disclaimer: this is not financial advice. It’s general in nature only and does not take account of your specific financial circumstances, or risk tolerance.

Disclosure: The writer has a short position in the Australian dollar. That means if the dollar falls, he may profit.

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.