Why the Aussie dollar won’t recover

As a financial commentator I can’t help but notice Australia’s little obsession with the local currency.

It’s a regular feature in the news.

That’s for good reason too: it influences how much we pay for fuel, for products manufactured off-shore, for overseas holidays, and indeed it influences the very health of our economy.

The Australian dollar has had quite the ride over the past 15 years. In April 2001 it hit a record post-float low of 47.70 US cents.

By July 2011 it was well above parity against the greenback at around 110 US cents. In between it plunged to around 60 US cents during the height of the financial crisis in October 2008.

As Australia’s economic condition has deteriorated over the past four years, and other major economies and manoeuvred policy, the Australian dollar has declined.

I’m now going to outline why there is little if any upside potential for the Australian dollar for the foreseeable future.

While I feel your pain if you buy a lot of imported goods, you’ll hopefully see why it really is in Australia’s long term interests to have a dollar that’s under pressure.

Let me outline what’s currently influencing the Aussie dollar.

Also read: Aussie dollar to hit pre-GFC lows

US interest rates

In December last year the US Federal Reserve raised its benchmark interest rate by a ‘token’ ~25 basis points or a quarter of a percentage point. It was token because there was very little science involved.

It was more of a gesture to reassure the markets that the Federal Reserve hadn’t forgotten about the concept of tighter monetary policy.

That’s understandable considering it had been nine years since the last interest rate increase.

The central bank could have just as easily kept interest rate unchanged, but an increase in interest rates had been talked about as far back as 2013 and it was – as far as the press was concerned – now or never.

To use a silly example, you can’t talk about asking a girl out forever… at some stage, you’ve just got to pluck up the courage and ask her to dinner. As for whether she says yes or no? Well you just have to risk it.

Now the Fed didn’t ask a girl out to dinner, it suggested a very brief morning tea catch-up. It didn’t put on any big moves either.

Fed chairwoman Janet Yellen emphasised the word “gradual” to describe the pace of coming interest rate increases in the United States.

Yes, interest rates are on the up, but that’s really all we know at this point.

Still, that’s enough for Aussie dollar bears at the moment.

As US interest rates rise, no matter how slowly, the interest rate differential between the Australia and the United States will narrow. Over time, the ‘yield benefit’ of having money parked in Australian cash assets will diminish further.

As it does, there will be less demand for Australian dollars and the value of the local currency will fall against the greenback.

The only way this could be halted is if the Reserve Bank was suddenly forced to raise interest rates, but, frankly, there’s a snowball’s chance of that happening given the fragility of the Australian economy.

Yuan

When news broke last week of the plunge on the Shanghai Composite, and the engineering of a lower yuan, markets went into a tailspin… again.

The initial market reaction came off the back of some weaker-than-expected economic data.

Let’s be clear about this though, China’s economy is slowing. It’s simply impossible for an economy to grow at break-neck speed indefinitely. Economics is like physics – it’s bound by laws.

Take something too fast or too high and it will rattle and shake, until it eventually breaks down.

Every time global markets are reminded about how much the Chinese economy still needs to cool, it suffers some sort of anxiety attack.

If the Chinese economy does indeed slow to 5 or 5.5 per cent, Australia’s economic growth prospects, and the dollar, will be considerably diminished, but that’s still a way off yet.

In the meantime, policy makers in Australia and China are working over time trying to figure out legitimate alternative sources of growth.

For China, that almost certainly will involve further devaluations of the yuan and losses for the Australian dollar, as it reflects China’s changing and perhaps deteriorating economic outlook.

Also read: All eyes on the Aussie dollar as Australia stalks recession

Commodities prices

Last year we saw the demise of many internationally traded commodities. Among them were the prices of iron ore and coal: two of Australia’s key exports.

Coal has been falling out of favour for longer than iron ore, but they’re both struggling right now.

The Australian dollar is a “commodities currency”, which means its value is very much tied to movements on commodities markets.

For instance the Australian dollar hit a post-float record high against the greenback when both coal and iron ore were at recent peaks.

It’s no surprise then that the dollar has followed both commodities, and oil, down to current levels. I forecast iron ore, coal, copper, and oil have further to fall.

That means the Australian dollar also has further to fall.

Incidentally too of course you have to purchase Australian dollars to buy Australian commodities (we can’t do much with yuan!), so as exports like iron ore falter, there is less demand for the AUD in commodities markets.

Sentiment

For such a small currency it is a little unusual that the Aussie dollar is such a great measure of sentiment or risk appetite in the market.

Perhaps it’s because it’s such a highly traded currency, and has such close links with the world’s second largest economy.

Simply put though if the Aussie dollar is high, it means there’s plenty of confidence and risk taking in the market, and if it’s low, it means many aren’t confident about prevailing economic conditions.

Indeed if there is a sharp drop on the markets the Australian dollar will often fall in sympathy. If the governor of the Reserve Bank gives a particularly positive outlook for the economy, however, it lifts in conjunction with that.

I’m told repeatedly that business confidence needs a boost, and consumers are simply taking advantage of record low interest rates and leveraging-up to spend, and that the “animal spirits” of the economy are yet to return following the financial crisis.

With a federal government in structural deficit and the global economic environment still so uncertain, the current climate is likely to remain for a while yet. In turn the Australian dollar will remain subdued.

Also read: Is Australia's economy facing another sluggish year?

Good for most

The dollar was floated by the Hawke government in 1983 to try to insulate or buffer the economy from international economic shocks. It’s designed to have a ‘smoothing’ effect for an “open” economy like Australia’s.

If the Australian dollar was still above parity with the greenback, the economy would be in dire straits.

While imported goods would be dirt cheap, Australia’s exports, which have been the backbone of the economy for the past two decades, would be highly uncompetitive. I suspect China would have taken its business elsewhere, perhaps to Brazil.

The lower dollar also encourages more domestic travel, and attracts foreign students to our education system. According to the Bureau of Statistics, export income from Australia’s international education services sector reached a record high of $17.6 billion in 2014.

Companies with businesses in the United States also benefit from the currency exchange when profits are repatriated to Australia.

Bad for some

Of course a lower dollar means those who import goods have to pay more for them, and retailers who on-sell foreign goods offshore have to manage the lower quantity demanded from consumers.

It’s also a real pain in the neck if you’re looking forward to that trip to the United States.

You’ll know all too well that your trip looks to be getting more and more expensive as time goes on. If you can book and pay for accommodation early, that could ease the pain.

Also read: How will the Aussie economy perform in 2016?

Where to from here?

The Australian dollar is what’s called “range bound” at the moment, which means there isn’t anything significant pulling it one way or the other. Indeed it could move a cent or two higher from here.

Longer term though, the dollar is heading lower. It may not be cause for financial markets chest beating, but the mighty Australian dollar is doing its job protecting us from dangerous global economic trade winds.

Indeed there’s every likelihood it will continue to take the economic hits most of us would otherwise feel.

 

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.