More all time highs this week for the Australian dollar against the US currency.
According to the AMP’s chief economist and strategist, Dr Shane Oliver, we are going to have to live with a strong currency for some time to come.
He makes the very pertinent point:
"The strong Australian dollar will likely cause more pain for internationally focused Australian companies that don’t have a natural hedge in the form of higher commodity prices like resources companies do.
"However, on balance a strong $A is positive for the Australian economy, and is part of the adjustment made necessary by strong demand for Australian raw material exports.
"It’s worth bearing in mind that strong and successful economies tend to have strong currencies.
"If a weak currency was the way to permanent prosperity then Bolivia and Zimbabwe should be topping the world per capita GDP tables, which they clearly do not!"
After being stuck in a narrow range around parity against the $US since last October, the Australian dollar has reached a new 29 year high.
The strength in the $A reflects renewed $US weakness, strong commodity prices and relatively high Australian interest rates.
My view for some time has been that having breached parity against the $US, the $A would head to $US1.10. Allowing for usual currency volatility this still seems on track.
The bigger picture – a falling $US
First, to the US dollar. A major part of the Australian dollar’s strength over the last decade has been the downtrend in the US dollar.
After a pause this appears to be resuming.
Further $US weakness is likely.
The US Federal Reserve is signalling no urgency to raise interest rates at a time when other central banks are either lifting interest rates or contemplating lifting them.
In addition, rising global investor confidence is reducing demand for the US dollar as a “safe haven”.
The converse of US dollar weakness is renewed strength in a range of other currencies:
The euro is looking stronger on the back of European Central Bank (ECB) talk of a rate hike, and confidence problems to Greece, Ireland and Portugal.
Asian currencies have risen to the top of their recent range against the $US. With the Renminbi steadily appreciating against the $US and interest rates still rising across Asia, it’s likely Asian currencies – including the Korean won, Taiwan dollar and Singapore dollar – have more upside.
The Yen strengthened after the Japanese earthquake.
This has since been short circuited by G7 intervention, confusing the outlook for this currency.
A weaker $US is also likely to coincide with a stronger $A.
Strong commodity prices
Despite a brief dip as a result of the Japanese nuclear crisis, commodity prices have shown renewed strength.
This reflects strong growth in Europe, expectations of rebuilding demand for raw materials from Japan, turmoil in the Middle East and North Africa boosting energy prices and expectations Japan’s nuclear crisis will add to demand for oil, gas and coal.
With the industrialisation process in China and other emerging countries likely having much further to go and supply likely to continue to struggle to keep up, the uptrend in commodity prices likely has years to run.
And, of course, a weak $US is also positive for commodity prices as the latter are priced in US dollars.
Australian commodity exports such as iron ore, coal and liquid natural gas are all key beneficiaries of this.
Commodities make up 70% or so of Australian exports and so the strength in commodity prices has seen the ratio of Australia’s export prices to import prices, or the terms of trade, rise to its highest level since the early 1950s and it is continuing to surprise on the upside.
As can be seen in the next chart the $A has tended to lag the strength in the terms of trade.
The last time the terms of trade was this high, in the early 1950s, the equivalent of one Australian dollar bought $US1.12.
Relatively high interest rates
Australian interest rates at 4.75% are well above those in the US, Europe and Japan where the range is zero to 1%.
While the ECB is likely to raise rates next month to 1.25%, there is unlikely to be much follow through and the Bank of Japan has been undertaking more (quantitative) easing.
Meanwhile the Fed is likely to be on hold for some time.
By contrast, Australian rates are on hold but the Reserve Bank’s bias remains towards more tightening which we expect to occur during the second half as Australian economic growth rebounds on mining investment, Queensland production returns to pre flood levels, flood related rebuilding kicks in and as national income remains strong on the back of high commodity prices.
By year end the interest rate differential in Australia’s favour is likely to have increased to around 5% against the US and Japan and 4% versus Europe.
This has the effect of attracting funds to Australia, which in turn pushes up the $A.
A longer term perspective on the $A
The general consensus seems to be the Australian dollar is way overvalued and that parity and above is unsustainable.
By contrast we think parity and above is sustaina
