Australian dollar set to fall far and fast?

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Some folks are probably a little bemused by recent action in the Australian dollar. After all, it has dropped hard in recent weeks just as Australia bulk commodities and terms of trade have gone through the roof, which is quite unusual.

The reason for this is that the US dollar has been on a ripping charge since the election of Donald Trump as two forces come to bear on the forex market. The first is that a large Trump stimulus has lifted inflation expectations dramatically and Federal Reserve rate hikes are being priced more swiftly as a result. The second is that the nature of the Trump victory – riding the de-globlisation revolution – has severely undermined the euro as its nations enter a troublesome period of elections any one of which might put in train further fragmentation of the monetary block.

Other major currencies in Japan and China are still busy devaluing as well so that has made the US dollar the only forex game in town. I see it racing to $1.10 on the USD index (DXY) over the next year. Moreover, if Europe does threaten to unravel, I expect the safe haven trade into the USD (and gold) to support it anyway.

So, the Australian dollar has been falling not because of itself but, rather, because the USD has been so strong. To measure how this effect may play over the next year I’ve chart the history of the AUD/USD cross versus the DXY basket comparing year on year percentage changes:

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The chart shows that during the first mining boom phase pre-GFC it was the weak USD that was the dominant price setter for the AUD/USD. But that relationship reversed after the GFC when it was Australian dollar strength that played the dominant role.

However, the two are clearly closely related and second chart illustrates just how much:

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Moreover, the great period of separation from the DXY post-GFC was related to Australia’s extraordinary terms of trade boom:

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This is more art than science but it does suggest two things:

  • that during periods of DXY strength, the Aussie dollar is usually very weak, and
  • that during periods of terms of trade strength that relationship diminishes, and, by extension strengthens again when the ToT falls.

That is all a rather long-winded way of saying that over the next year the Australian dollar is going to enjoy two very large headwinds and potentially equally impressive falls as:

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  • today’s bulk commodity bubble deflates taking the ToT down with it, and
  • the US dollar runs riot.

The major risk to this outcome is probably a European political quagmire that is bad enough to delay Fed rate hikes but not severe enough to trigger a safe haven event.

Also Check – Australian Dollar Analysis, News and Forecasts

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.