Stronger for longer

See the latest Australian dollar analysis here:

Macro Afternoon

As readers know the USD, as the other side of the AUD/USD coin, is one of my 5 key drivers of the Aussie as I have discussed before. So where it’s going and what it’s doing is a key to divining the future of the Australia dollar. 

Since the mid-1990’s, starting with Robert Rubin, US Treasury Secretaries have from time to time felt the need to reiterate the so-called strong dollar policy. The current US Treasury Secretary, Tim Geithner, reiterated this in a discussion  at the Council on Foreign Relations in New York on Tuesday night our time. Bloomberg quotes Geithner as saying:

Our policy has been and will always be, as long as at least I’m in this job, that a strong dollar is in our interest as a country,…We will never embrace a strategy of trying to weaken our currency to try to gain economic advantage.

But as the chart (from Bloomberg) below shows there is little recent evidence that this is the case:

Since August last year the USD has lost almost 19% against the AUD and CHF (Swiss Franc), 12% roughly against the EUR and Brazilian Real and even more starkly almost 5% against the GBP (British Pound), a currency backed by an economy that has had no growth for the past 6 months, 4% inflation and is waiting for austerity to really bite.

So you could be excused for thinking that Tim Geithner was being disingenuous with his comments above about his belief in a strong dollar. I’d argue the US Administration has not been bothered by the US Dollar’s weakness up to this point and while they may not be directly running a policy to weaken it, their mates at the Federal Reserve have effectively flooded the market with greenbacks, pushing the price down as supply has outmatched demand. 

There are two questions worth trying to answer then. First, why has Geithner decided to roll out Bob Rubin’s old mantra and secondly what really is in store for the USD (and consequently the AUD) in the next 6 months or so.

Looking at the first question, the answer is that he was asked a direct question at the talk the other night and needed to give a fairly strong answer. The reason for this is that currency traders ears are very attuned to the comments of US Treasury Secretaries because they don’t  cover this topic too often, unless they have to.  Back in 2001 US Treasury Secretary Paul O’Neill when faced with a similar question and gave an honest answer saying:

We are not pursuing, as often said, a policy of a strong dollar. In my opinion, a strong dollar is the result of a strong economy.

No prizes for guessing what happened next, currency traders thought he was signalling that the US did not support a strong dollar and the US Treasury Department had to release a statement to say there had been no change policy and that the Secretary supported a strong dollar. 

Indeed a couple of week’s later in 2001 O’Neill was forced to make the following statement.

I guess I made a mistake in thinking it was okay to talk beyond simplistic things. So I’ll make it very clear: I believe in a strong dollar, and if I decide to shift that stance I will hire out the Yankee Stadium and some rousing brass bands, and announce that change in policy to the whole world.

Now as the chart below shows O’Neill had the luxury of making these comments when the dollar was at or near the top of a 5 or 6 year uptrend and even then the USD got smashed. So when faced with a similar question Geithner has no choice given that the USD index is only 3 or 4% above the low of the last 20 years. To do otherwise than reinforce the “Strong Dollar Policy” risks a USD rout:

But the USD is in bad shape at the moment. The fact that it has lost ground to the GBP tells us that even if the price action in the above chart doesn’t shout it loud enough. So let’s look at the second question of what might be in store for thee USD in the next 6 to 12 months. 

After Chairman Bernanke’s testimony overnight it is clear that QE is going to go till June but that it is likely to stop then. Bernanke said overnight it is the stock of what the Fed is holding not the flow of what the Fed is purchasing is the key to the accommodation in the economy. So even if they stop purchasing and there is no QE3 he sees monetary policy as loose.

I’ve made the case  in the past that the Fed’s balance sheet growth has been inflationary for asset and commodity markets so I guess the corollary of this is that once they stop expanding, the USD will find support. But is this support likely to be weak, strong or absent?

Work by an old colleague of mine, Richard Franulovich who is Senior Currency Strategist at Westpac in New York suggests that any USD strength may be transitory. This is not good news for Aussie exporters or import competiting industries. Richard says that the USD will find a base but that:

It might not last long though – going back 25 years the USD has struggled in the early stages of tightening. Slide 4 shows the behaviour of key variables a year into the last 5 Fed hike cycles. On average, 1 year into tightening the Fed lifts cash by 2ppts, yield spreads move 150bp in the USD’s favour and the yield curve flattens 80bp. Yet, the USD tends to struggle. That might reflect the fact that commodities and equities rise in the first year of hikes too (see slide below). The Fed lags the Taylor path early in a hike cycle too implying that real interest rates remain low (i.e. it takes a certain amount of hikes before the USD can rally).


Indeed, when Richard looks at the performance of a number of markets on average over the last 5 US tightening cycles we see that the AUD’s current strength may actually out last even the most bullish buyers:

You’re probably asking how relevant the last 5 cycles are compared to this one, which is all about the end to the debt super cycle,  and you could probably argue not overly. But if the GFC has taught us anything it is that the most dangerous words in the English Language are “this time its different”. 

So the balance of probabilities are that the USD may find support soon around 3-4% lower than where it is now which translates in an AUD around 1.1175 to 1.1284. Please note this is not a forecast, and I am hearing that real money buyers are finally starting to say enough is enough, at least for the time being. However even though I am uncomfortable writing this next sentence (and I could be ringing the bell for the top) unless something changes fundamentally for the USD, the Aussie’s strength looks like it might persist stronger and for longer than many think.

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  1. Top post!

    Another reason to suspect there might be a turn soon is sentiment, it is extremely lopsided. The mainstream media articles and also general workplace chat has changed the tune from earlier in the year (eg. there’ll never be a better time to holiday in the US or import from the US) to this week starting to cheer the AUD on (eg. One headline this morning read “Aussie dollar to surge to 1.12”)

    When sentiment gets extremely lopsided, as now (extremely bullish), it indicates that everyone who is likely to buy, already has. So there are not many buyers left. To bank profits, at some point all those AUD/USD owners will need to sell. Should be a huge rush for the exits at some point.

    Price action over the last decade suggests a possible target of 1.115:

    That said, anybody who would short the AUD/USD now, is possibly someone who’d enjoy standing in front of oncoming freight trains. Not my idea of fun!

  2. and even more starkly almost 5% against the GBP (British Pound), a currency backed by an economy that has had no growth for the past 6 months, 4% inflation and is waiting for austerity to really bite.

    Adam Carr also has some thoughts today on the GBP and British economy…

    The British pound in particular, rising by over a big figure (compared to 1630) to sit at 1.6630. The reason for this outperformance was because GDP came in as expected at 0.5 per cent in the first quarter. Notionally this removes the last obstacle to a near-term hike although I suspect the MPC will be very reluctant. The case to remove rates from a record low is clear enough, what with inflation well above target (excluding currency and VAT impacts) and now as we learned last night that the UK economy is nowhere near a recession.

    Just so you know: The UK is nowhere near recession and there are no obstacles to a near term hike.

    Are austerity measures about to bite? Not in Adam Carr’s universe!

  3. Dont yu have better things 2 do than compare toilet paper with each other? yawn nothing 2 see here

    • Deus Forex Machina

      unlikely…results of the 1 bill in july and 1 bill in august tnotes offered showed a bid to cover ratio of >4.7 to 1 and they went below bbsw for the same period…

      this is just the usual stuff in terms of issuance

      from an fx perspective they are taking aussie out of the market….ie offering an investment if they were intervening, which they werent but lets extend the hypothesis, they would need to be offering aussie to the market to make it more available and thus attempt to push the pricec down…that would be a reverse we want to invest in your stuff and give you aussie…think QE

      as for the aud’s price action on the chart…just noise, its a very short term “tic” chart

      hope that helps

  4. Can you imagine what this is going to do to the Australia tourism, manufacturing, and other industries. When the commodity boom is over with there isnt going to be much left in Australia. I just cant believe so many Australians are celebrating this. China and the US are in a currency war plain and simple.

  5. DFM, I’ll scope your opinion if I may.

    I’m off the belief there is much speculative and arbitrage behaviour in our dollar at the moment. Some party is making some profit out of it.

    For argument’s sake, well even designate it a super profit.

    If the government wanted a clip of this super profit, say implemented an extraordinary, and temporary policy that added a levy, in effect widening the buy-sell spread.

    What do you think that would do overall?

    • Deus Forex Machina

      The sort of thing you are thinking of was first suggest by an American Economist, James Tobin back in the early 1970’s.

      Tobin reckoned “currency exchanges transmit disturbances originating in international financial markets. National economies and national governments are not capable of adjusting to massive movements of funds across the foreign exchanges, without real hardship and without significant sacrifice of the objectives of national economic policy with respect to employment, output, and inflation.”

      So currecny speculation isn’t such a good thing and that shorttermism should be discouraged. So he thought charges should be added to round trip trades in what is essentially a transaction tax.

      It’s now called a “Tobin Tax” and it imposes a levy on all foreign exchange transactions.

      The problem I have with a Tobin tax is where does it cut in? Trades under 1 day, 1 week, 1 month, or a year. I think also that the tax could actually destabilise currency markets as they take away a lot of liquidity. please note I’m assuming here policy makers want their cake and eat it too by simply imposing the tobin tax but not changing any other global currency or finanicial arrangememnts.

      But one other point worth making I think. Is it really just speculators trying to make money on the AUD’s rise? In part yes but how do you fight the economic and investmetn fundamentals that drove real money investors with big long term positions into the AUD and eaully how do you hold them in when their view changes?A tobin tax won’t do it.

      During the Asian Crisis Malaysian PM mahatir blamed the hedge funds for trashing the Ringgit but they were supporting it while the real money guys and locals bailed.

      So its not an easy answer.

      If as a country we value the industries that are being hurt by the strong dollar why cant we put together something akin to the drought packages we put together for farmers when times are hard. Seems to me its intellectually the same thing.

      Have a great day…DFM

  6. Here are some interesting thoughts from Chris Joye on the AUD/USD:

    Yet the major downside risk for the Aussie is, of course, the US dollar. The recent surge in the Aussie/USD pair has been a USD depreciation story. That is, the USD has been falling against all major currencies. This has has been driven by the maintenance of incredibly low US interest rates in contrast to almost all other central banks.

    However, as both core and headline inflation in the US now accelerate, and activity gradually recovers, the Federal Reserve has made it clear that it is stopping QE2 and will start thinking about contracting its balance-sheet. This will represent a normalisation of monetary policy and result in higher US interest rates. Put another way, if you think the US is going to have an inflation challenge going forward, you have to be bearish on the Aussie/USD pair.

    In summary, over the next 12-24 months, there are likely to be strong headwinds faced by the Aussie. More significantly, the RBA would be silly to rely on continued appreciation in the AUD as a reason for forestalling monetary policy tightening. The risks here are quite the reverse: a substantial 10-20% depreciation in the Aussie over the next 12-24 months care of rising US yields could produce strong domestic inflationary pressures at just the time that the capex boom is taking off. And to the extent that the RBA substitutes currency action for interest rate action, this could be self-fulfilling given the exchange-rate is priced off global interest rate differentials.

    CJ is literally screaming for a rate hike. It seems he wants to bring on a housing correction ASAP.