The Australian dollar has recovered sharply from its lows last year reflecting a combination of $US weakness, stronger commodity prices and the likelihood Australia will be the first major country to start raising interest rates.
While a short term correction in the $A looks likely, the broad trend in the $A is likely to remain up reflecting the realities of a commodity constrained world and the relative strength of the Australian economy. Another go at parity is likely next year.
The dollar hit a new 13 month high of 88.47 US cents overnight Wednesday.
That was more to the weakness in the greenback meeting renewed demand for Australian dollars ahead of an expected interest rate rise from the Reserve Bank.
The AMP’s Dr Shane Oliver says this presents obvious challenges for the Australian economy as trade exposed manufacturers and service industries suffer a loss of competitiveness. For investors, it means there is a case to limit exposure to unhedged international investments.
The Australian dollar is up 45% from its low of $US0.60 in the midst of the global financial crisis late last year.
The rebound has been driven by a combination of the renewed weakness in the $US, the recovery in commodity prices and the relative strength in the Australian economy.
While the $A is vulnerable to a short term correction following its recent break higher, our assessment is the rebound is sustainable and has further to run.
$US weakness likely to continue
After rising through the global financial crisis on the back of safe haven buying and demand for US dollars to repay $US denominated debt, the $US has resumed its downswing against major currencies. See the chart below.
While we are unlikely to see a crash in the value of the $US – as the euro and yen are hardly attractive alternatives and the Chinese won’t allow a rapid rise in the value of the Renminbi – a recovering global economy is likely to see further US dollar weakness on the back of declining risk aversion.
The $US is also likely to be a key funding currency for carry trades (where investors borrow cheaply in low yielding currencies and invest in high yielding currencies) – this is likely to be positive for the $A.
Commodity prices are likely to trend higher
Commodity prices have had solid gains from their lows late last year and this has also helped drive up the $A, along with other commodity currencies such as the Canadian dollar, South African rand and New Zealand dollar.
The oil price is up around 120%, base metals are up 78% and gold is up 42%.
Notwithstanding the likelihood of a short term correction, the trend in commodity prices is likely to remain up as the Chinese economy continues to reaccelerate, the US housing cycle bottoms, infrastructure spending globally continues to increase all at a time when commodity supply has been further constrained by the cancellation of various mining projects through the global financial crisis and investment demand for commodity exposure is continuing to grow.
Our view remains that commodity prices have now embarked on another cyclical upswing in the context of a long term bull market, or super cycle. See the chart below.
Australia is likely to raise interest rates ahead of other major countries
Australian official interest rates at 3% currently are well above those in the US, Europe and Japan where the range is zero to 1%.
What’s more, the fading of the global financial crisis (which led to the cut in Australian interest rates to an emergency low of 3%) combined with the relative resilience of the Australian economy and signs of economic recovery indicate that interest rates will soon start to rise towards more normal levels in Australia.
As a result, the interest rate differential in favour of Australia is set to widen, probably before Christmas.
On top of this, Australia is seen as relatively attractive to foreign investors to the extent that it came through the global financial crisis relatively well and it’s leveraged to strength in China.
All of this makes Australia reasonably attractive for foreign capital, and sees Australia as a key beneficiary of carry trades.
So how far can the $A go?
Trying to put a level on how far the $A will rise is impossible.
Back in 1900 one Australian dollar bought $US2.40 so it is still a long way down on where it has come from over the last century!
More fundamentally though, there is good reason to believe the $A is on its way to another re-test of parity against the $US.
The last time Australia’s terms of trade (the ratio of export prices to import prices) was at current levels was in the early 1950s and back then one Australian dollar actually bought $US1.12. See the next chart.
The impact of a rising $A on the economy and shares
From an economic perspective, the rise in the Australian dollar is a mixed bag.
To the extent that it’s a positive sign regarding the global growth outlook and that it will reduce the cost of imported goods to Australia and hence inflation, it’s good news. It’s particularly good news for Australian consumers with imports comprising about 30% of consumption goods – so consumers will see lower prices than otherwise would have been the case for fuel, cars, clothing, many electrical goods and overseas holidays.
But it’s bad news for
