The great Aussie battle

See the latest Australian dollar analysis here:

Macro Afternoon

Is the AUD weak or strong? It’s hard to tell because it seems to find support above .9950, like it did Friday night, but can’t get through 1.02. This tight trading range has been in force for about 6 weeks now and has the bulls and the bears excited in equal measure each camp expecting the Aussie to move its way sometime soon.

My feeling is that in a fundamental sense it is on tenuous ground at the moment whatever the overwhelming positives that accrue from a long term China Dividend and the massive boost in income and Terms of Trade for Australia. I think all the good news is priced in. But I can equally see the argument that on a fundamental long term basis its going higher. Indeed I can see how some people get it trading at 1.10 at some point because the fundamentals that underpin the Aussie and the Australian economy are so strong across the decade. Unless of course global growth has a misstep which is where I guess my personal scepticism comes in.

That’s pretty much exactly why you get these types of trading ranges, there is merit on both sides of the argument but no short term catalyst to push it outside the range.

On the question of whether or not all the good news is already priced into the Aussie, Westpac Chief Economist Bill Evans offered the strangely titled piece “WEEKEND ECONOMIST: Australian dollar drop” but the entire article was about a re-rating of Australia and the Aussie. Bill called it a “new found respectibility” and gave it as why the Aussie hasn’t fallen out of bed recently amongst all the turmoil and particularly the oil increase:

The dogged resilience of the Australian dollar to the relentless surge in the oil price (up 21 per cent since late January) has been remarkable. Over the last month, volatility in the US equity market has increased by 18 per cent whereas one-month volatility in the Australian dollar has fallen by 11.5 per cent. Recall that the Australian dollar has in the past been the currency of choice to “attack” at times of global unrest. Higher oil prices which are caused by supply shocks should be seen as a precursor for slower global growth and risk currencies – headed by the Australian dollar – should be sold. If prices are rising because of stronger demand, as we saw in 2008, then because Australia is seen to be a major exporter of energy, the Australian dollar would be supported.

The resilience of the Australian dollar to this supply shock could be related to a new found “respectability” of the Australian dollar.

Let me summarise the key points of his article:

1.    Australia’s current account position has improved materially from 6% of GDP and can be sustained in the 2-3% region for some time.

a.     While there is a 2% trade surplus the cost of servicing the stock foreign liabilities is 4% of GDP.

b.    Crucially though half this cost arises from equities and direct investment dividend flow which is effectively fixed according to internal economic dynamics not floating at a predetermined rate.

c.     Thus the CAD has inbuilt stabilisers in it and not as bad as the raw number a suggests

2.    The funding task for Australian banks offshore is going to be lower in the coming years coming from a rise in the savings rates for households and corporate and a fall in demand for credit. (not good for banking profits though – but I’ll leave that to others who have discussed that on this blog).

3.    The US economy is too weak to sustain tightening leading to another round of quantitative easing

So, you may ask, how does all this positivity tie back to a falling AUD?

Our forecasts envisage broad-based strength in the Australian dollar through to around the final quarter of 2011 when it will begin a period of correction, mainly driven by a reversal in commodity prices. That reversal will be relatively modest since other factors which have generally supported the Australian dollar will remain positive. Nevertheless, our research indicates that commodity prices are the dominant driver of the Australian dollar, unless there is a major US event such as the advent of further quantitative easing.

So the AUD is going to be strong until its weaker. Yep that’s it.

Time will tell. Traders will continue to trade the range while it persists building up tension for an ultimate break. As Minsky says, stability breeds instability. Indeed such is the balance of bulls and bears that it could break north equally as well as south in the short term but I’d rather miss the rally than chase the Aussie above 1.0250. It seems to me that whatever the short term price action global uncertainty is growing. Am I doing the same thing I am accusing the economics fraternity of? To a certain extent I am but history tells me that too much of a good thing for the Aussie is bad particularly when uncertainty rises.

No denying that commodities are a dominant driver of the AUD and no denying the new-found respectability of the AUD either. Mostly I think this is accruing from the China dividend and is susceptible to any Chinese reversal.

Equally I don’t disagree the AUD has held up well but I also don’t think we have seen a “real” risk off event yet that threatens the AUD. So this respectability hasn’t really been tested. Last week’s equity swoon was the closest we’ve seen so far but generally all we are seeing is pockets of disquiet over oil not wholesale fear and certainly not a re-thinking on global economic growth or China yet.

But potentially we could have a situation where most, if not all of the good news is priced in, is because I think a lot of people think the AUD will do ok and then fall later this year. In a forecasting sense they want to say the Aussie is ok for now but call it lower later. That way they are right even if they are wrong. The AUD either falls sooner than their forecasts and they are ok because “they called it” or it strength persists and they just extend the time to the fall.

Now this is not to attack Bill, not at all. I have worked with Bill in the past and been a keen follower of his and his team’s work. He is genuinely and generally one of the few Senior Economists who are prepared to stand apart from the crowd of conventional wisdom and other economists. But his article highlights a trend I am hearing a lot at the moment.

That is everyone seems to think the Aussie is going to go up or be strong, then down.

So how much of this good news is priced in. I think a lot of it.

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  1. depends when all the speculators sell the AUD when the carry trade breaks, must be nice to get free $ in america and then buy higher yeilding “investmests”. Sounds like another ponzi i need some free money as well.