Why I’m staggered the Australian dollar hasn’t crashed

It’s one of those “what the?” moments.

If you have a good long hard think of what drives the Australian dollar, and you look at where most traders are placing it into the future, it’s a little confusing.

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The Australian dollar is a reasonably straight forward asset to value. Most Aussie dollar valuation indicators point to the dollar being valued roughly where it is at present.

It’s the outlook that confuses the hell out of me.

So let’s look at what’s influencing the dollar? And where it’s likely heading.

Commodities

If you look at a chart of Iron Ore fines 62 per cent FE CFR Futures (OK that was a gratuitous use of a technical trading term) over the past 12 months, you’ll see the price of iron ore peaked over the New Year.

There was a similar high in the Australian dollar.

Cutting a long story short, the Australian dollar has been dubbed a “commodity currency” because it rises and falls on, well… commodities. Particularly the price of iron ore.

The price of iron ore has been steadily declining since the start of 2018. So, it makes sense that the Australian dollar would also now be under pressure. What’s more striking than that though is that if you look at the price of iron since the height of the mining boom in 2010, there’s a clear downward trajectory. There’s no mistaking it.

So what’s the outlook for commodities prices, and the price of iron ore?

My guess is that if China’s economy keeps slowing, as it has been doing now for close to a decade, that will simply feed into the iron ore’s ‘demise’.

That’s a slow-grinding negative for the Australian dollar.

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Trade war

That leads in rather neatly to geo-political concerns. That’s another factor that drives the Australian dollar’s movements.

Make no mistake, a trade war between China and the United States has begun. It became official on the 6^th of July.

Just after midnight on Friday, the United States and China began a $34 billion tariff war. The US duties affect products like X-ray machine components, aeroplane tires and various other industrial parts. The Chinese have targeted soybeans, pork and electric vehicles.

This is protectionism.

Some have argued it will re-direct export interest and investment flows to Australia, but as well-known day trader Henry Jennings, from Marcus Today, put it, “let’s face it, there are no winners in a trade war.”

My feeling is that if, and that’s a big “if”, the trade war escalates, the Australian dollar will be caught in the cross fire. That’s a very loose way of saying that a trade war will likely hurt both countries’ growth prospects – because we live in a world that depends on free trade – so a long-lasting, deeply entrenched trade war will likely feed back to Australia negatively by its overall impact of China’s economic growth.

Right now the threat is relatively minor because only 3 per cent of trade has been affected. But my fear is that it’s a negative for the Australian dollar.

Interest rates

I want to turn your attention now to global interest rates.

You can get so lost in this section so let’s keep it really simple. Traders often buy currencies so they can invest in the country of that currency. It’s called a “carry trade”. You borrow money from a low interest rate currency, and invest that money in a high interest rate currency. Pretty simple really.

For the first time in a long time, Australia’s short-term interest rates are lower than that of the United States. For many years it made sense to borrow US dollars and buy Australian dollars (to invest in higher interest rate Australian assets/deposits). Now the reverse is true.

Australia’s relatively low interest rate environment will now turn investors away.

That leads to a critical point though. Despite two Federal Reserve rate rises this year to a range of between 1.75 percent and 2.0 per cent (note Australia’s cash rate remains at 1.5 per cent), long-term rates are now struggling too. The rate on the 10-year US Treasury note for instance is still under 3 per cent.

It’s causing the yield curve to flatten – a major red-light warning for a coming recession. In simple terms, those who trade these longer dated debt securities are not confident enough to bet that interest rates will be much higher in the future – or, better put, that the economy can cope with interest rates even as high as 4 per 5 per cent.

That’s all negative for the Australian dollar.

Bond buying

One aspect of the Australian dollar we haven’t spoken about is interest in Australia’s debt market.

The Australian government is one of a few around the globe that can boast a consistent AAA credit rating. Australia is considered a relatively peaceful, well regulated nation, and therefore attractive to anyone who wants to invest in a security that’s backed by the government.

Fierce buying of Australian bonds, I’m told, helped push the local unit up to the 80 cent mark against the US dollar recently. It’ll be interesting to see if the bond market can come to the rescue this time around.

Risk appetite

Australia’s Dollar is down over 5 per cent against the greenback, and around 3.5 per cent against Pound Sterling so far in 2018.

That’s a significant decline. It’s certainly one worth noting, especially in the context of deteriorating global “risk” sentiment, or confidence. The Australian dollar is considered a bit of a proxy for risk sentiment, and with political instability in Europe, a trade war between China and the US, and concerns over emerging markets… well, yes, it makes sense the Aussie dollar would be capturing that malaise.

Outlook

I’m staggered the Aussie dollar hasn’t crashed.

The last time the interest rate and bond yield differentials moved so heavily in favour of the US Dollar was back in 2000. Then, the AUD was trading at 0.50 US cents.

I see plenty of other negatives to knock the wind out of the currency and yet the dollar refuses to sink below 70 US cents.

I’m told current levels for the Australian dollar are about right, in terms of benefits to the Australian economy. And goodness knows we don’t want a plunging currency to bring about “imported inflation” – which would drive interest rates higher.

At the same time, I can’t help but think the Australian dollar has another leg to go down.

From a technical perspective, there’s a major “support” level for the Aussie dollar at around 63 US cents. It bounced off that support back in 2009.

I’m not keen to see that level tested again.

@DaveTaylorNews