The Australian dollar has recovered strongly from the lows earlier this year: it’s up more than 20% in the space of a few months.
Overnight it closed above 78.5 US cents and has touched a series of seven month highs in the past couple of weeks, thanks to the easing of risk fears globally, the growing suggestions of strengthening economic conditions (or rather an ending to the freefall) and rising commodity prices off the back of a weak greenback.
The AMP’s Chief Economist, Dr Shane Oliver says the rebound in the $A reflects a combination of renewed $US weakness, stronger commodity prices and the relative strength of the Australian economy.
Commodity prices seem to be recovering earlier than normal in this cycle reflecting the role played by China, infrastructure projects and supply cutbacks.
The commodity super cycle looks to be alive and well. While the $A is due for a correction, in the absence of a major setback in the global economic outlook the broad trend is likely to remain up.
A big surprise this year has been the strength of the $A. It has now recovered nearly half of its global financial crisis driven plunge.
Several factors are at work: renewed weakness in the $US, the recovery in commodity prices and the relative strength in the Australian economy.
The big question is – can the strength in the $A be sustained?
Reason #1 – Renewed $US weakness
As is often the case, the latest strength in the $A is partly due to renewed $US weakness.
From mid last year to early March – which was the weakest period in global share markets – the $US actually rose in value by an average of about 25% against major currencies. (See the chart below).
In fact, as is often the case during global economic slumps, the $US actually rises in value.
During crises the $US is seen as a safe haven – US investors bring their money back home and, reflecting its reserve status, demand for the $US goes up.
This is what happened during the second half last year.
Now with the financial crisis abating the $US is retreating with other factors also playing a role:
• As confidence in some sort of economic recovery and financial conditions have improved the need to hold US dollars and demand for it as a safe haven has declined.
• The fall in risk aversion is seeing a resumption of the carry trade (where investors borrow cheaply in low yielding currencies and invest in high yielding currencies).
The $US, with near zero interest rates, seems to have taken over from the Japanese Yen as the key funding currency for such trades.
High yielding currencies such as the $A are clear beneficiaries.
• There is increasing concern about the US budget deficit, fears of a ratings downgrade for US public debt and worries about the direction of US economic policy.
It’s doubtful that this is the start of the $US crash that has been long feared by many.
It’s hard to find any better alternatives to the $US. Europe and Japan are in worse shape than the US, have similarly eased monetary policy and have similar or worse public debt levels.
While a fall in the value of the $US will actually help the US economy, it will be bad news for Japan and Europe and is likely to be met with increasing resistance the further the $US falls.
The Chinese Renminbi is not really an alternative to the $US as an international reserve currency because it’s not even fully convertible and lacks anywhere near the liquidity of the $US.
And Chinese authorities are unlikely to sell or stop buying US bonds because such action would push up the Renminbi versus the $US (and damage their exporters), the very thing they have been trying to prevent.
But while a $US crash is unlikely, a recovering global economy is likely to see further US dollar weakness on the back of declining risk aversion and the resumption of carry trades.
A reasonable expectation is that the $US index in the first chart will fall back to last year’s lows, which would amount to a further fall of 10% or so against major currencies.
This is likely to be positive for the $A.
Reason #2 – Commodity price recovery
Industrial commodity prices have had solid gains from their lows late last year and this has also helped drive up the $A.
Oil is up 95%, base metals are up 35% and gold is up 34%.
Commodity prices usually track or lag the global economic cycle, as evident for base metal prices in the next chart.
However, apart from contract iron ore and coal prices which always lag, traded commodity prices now appear to be leading the global economic cycle.
There are several reasons for this changed relationship.
Firstly, commodity prices are also being pushed higher by the falling $US.
This partly reflects the fact that most commodities are priced in US dollars and so when the latter goes down the natural tendency is for them to go up.
Secondly, investor demand for commodities may be on the way back up being given an added impetus by the desire to find a hedge against the uncertain outlook for most key paper currencies and the risk of increased inflation.
Thirdly, and more fundamentally, the greater importance of China in commodity demand is playing a role in commodity prices more pre-emptive nature.
Since 2000 China has accounted for virtually all the growth in global copper consumption and now accounts for 35% of global copper demand.
T
