Australian dollar: Beautiful one day, dumped the next

See the latest Australian dollar analysis here:

Macro Afternoon

The Aussie Dollar has been the darling of the currency landscape for the past two years and its rise has rewarded well those who have ploughed their money into it. And as other risk markets swoon, just like a teenager after his first kiss, the love affair of forex traders, global portfolio managers and central bankers diversifying their sovereign assets has been intensifying at a scary rate.

Yet continuing the analogy, at its basest level, forex markets are just plain old beauty contests. Unlike the stock markets where you can by BHP or Woolworths and not be too concerned about where the others go, in foreign exchange when you buy one currency you are always selling another. In currencies it’s not about finding someone to love and hold, it’s about picking up and dumping, and then doing it all again the next night (when the markets open of course).

Still, there is a kind of logic to this sometimes grotesque ritual, and while fashions change over time, there are always core imperatives that traders keep in mind. In the case of the Australian Dollar versus the US Dollar these imperatives include:

  • global growth and commodity prices;
  • domestic interest rates and how they stack up relative to the rest of the world;
  • investor sentiment and risk appetite;
  • technical indicators, which are the tools that traders use to determine price actions; and, of course,
  • the issues on other side of the cross, i.e. the US Dollar.

The combination of these factors caused the local currency to head back to its recent high around 1.05, even though the Aussie, in the words of the RBA,

“…remains at a high level by historical standards, with the nominal trade-weighted index almost at the multi-decade high recorded in early March, despite a deterioration in the global economic outlook and a decline in the terms of trade.”

That is code for the Aussie hasn’t gone down as many thought it would have or should have.

But although the single input of commodity prices is a significant driver of the Aussie’s value, while the pheromones are strong the only thing that matters is sentiment. And while at Macro Investor we certainly hold the view that the pullback in global aggregate demand, commodity prices and, in particular, bulk commodities such as iron ore and coking coal, will matter, for the time being the music is playing, the liquidity is being drunk and these are problems for the morning.

Yet with every binge there is an equal and opposite hangover and eventually the spread between the AUD and commodities and the AUD and Australian government bond premiums will collapse.

For the time being, while interest rates in Australia are high relative to the rest of the world and while our banking and fiscal position, on the surface and including household debt, is so much healthier than the alternatives we are the prettiest girl in the room. Add in a triple-A credit rating and the risk-adjusted return on holding Australian government bonds, something which has driven foreign ownership from 60% in 2009 to 76.5% presently, and we’re also safe enough to take home to mother.

But in the same way the Aussie has benefitted from a positive feedback loop that drove it up to a high of 1.1080 in 2011, once the table turns all this will be forgotten.

Already, over the past week, the Aussie has underperformed the risk rally in equities pulling back to 1.04 rather than rallying up through 1.06, contradicting its supposed ‘safe haven’ status. What is driving this is hard to tell, except perhaps that if this is a genuine risk rally in equities and nothing else, but equally there is now talk of rotation out of the Aussie and into other currencies, which have lagged over the past year. The heady scents of the Mexican Peso and the Turkish Lira are the latest, more exotic attractions.

Like the proverbial movie starlet who suddenly stops getting the calls, will we be dumped for nothing other than not being pretty enough? It seems this may have already happened as allocations to Australia have stopped increasing at a rising rate.

Large debt overhangs globally and a Chinese slowdown are questioning rosy price assumptions for commodities, which in turn threaten announced capital expenditure, such as at Yancoal yesterday. Likewise, this dynamic threatens the federal government’s budgetary position and the margins of our major banks, which have been selling into the rallies.

The world still loves the Aussie it seems, at least psychologically, but its beauty is fading fast and in the cold light of day its value could easily diminish.

Greg McKenna is chief investment strategist at Macro Investor, Australia’s independent newsletter covering shares, forex, fixed interest  and property. He is the former head of currency trading at NAB and Westpac. Click here for a free, three-week trial to Macro Investor. This is an op-ed written for the Fairfax press today.

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  1. Hear hear. Your conclusions are especially pertinent if there is any dollop of accuracy in Chovanec’s view that “China’s economy is not just slowing, it is entering a serious correction. The investment bubble that has been driving Chinese growth has popped, and there are no quick “stimulus” fixes left. There is the very real possibility of some form of financial crisis in China before year’s end.”

  2. Agree – an extrapolation of what I said yesterday – if/when the boom REALLY falls off, the AUD will be dumped. The boom has been our sole point of ‘exceptionalism’. Without it we are in trouble. Possibly big trouble.

    • GunnamattaMEMBER

      We are in big trouble already.

      The mining boom just means the toast we need to face becomes darker by the time we get to it (and of course a few extra debt laden crumbs can be handed on to someone else – for them to pay back).

      What actually is the moming boom doing for the bulk of Australians at the moment? Making the services and goods they provide less competitive globally? Providing them an economic straightjacket of a hollowed out economy? Enabling them to have continued uber expensive real estate? Allowing governments to avoid making a rational economic adjustment? Letting some baby boomers off the hook?

      C’mon…. we can lance a boil today or tomorrow, but defering until tomorrow doesnt mean the boil wont have to be lanced.

      • If you believe half of what you have written you are entirely misguided.

        A recent entire issue of Foreign Affairs attempted to tackle the global challenge of retaining/regaining manufacturing capacity that has been radically reduced via the process of globalisation. We are no different. The move to offshore production is unlikely to be reversed, we are not cost competitive across a range of parameters – we are an expensive country to do business in. Our manufacturing economy has not been hollowed out by our resources sector but by the shift to offshore production – the constant search for cheapest cost production will not end. A lower dollar will not dramatically alter our manufacturing sector – we will still have high input costs, high wages and in terms of any imported product, considerably higher costs.

        The ‘hollowing out by resources’ is a meme that should be terminated if we are to seriously address a future sans resources boom.

        But thank god we have resources, because boom times will return. You can be sure of that.

        • While I recognize that the high dollar is adversely affecting trade-exposed industries at present, it is also correct that the decline in Australia’s manufacturing capacity is a trend that was both occurring before the boom, and would have continued without it. Scapegoating mining is an exercise in intellectual indulgence. It makes commentators feel good to have a conspicuously successful target to blame (often mixed with the perennial distaste certain segments of the political spectrum harbour for the industry). It is farcical to contend that Australia would have been better off without it over the past 5 years. Although, I do think a greater slice of resource profits going to the tax man is warranted, provided it can be put to the sort of productive use that Professor Schmidt has recently been advocating. (Perhaps that betrays my naivety of Australia’s political culture.)

          • “…I do think a greater slice of resource profits going to the tax man is warranted, provided it can be put to the sort of productive use that Professor Schmidt has recently been advocating…”

            My views on the mining tax differ but as to the second part of your final point: Alas, this is never likely to happen in this country and similar concerns were contained in an RBA paper which basically rejected the concept of a SWF in Australia.

  3. Thanks DFM, this analysis makes sense and after reading it and other posts here I am glad I diversified to other currencies recently.

    Luckily Australia is amongst the losers in this contest below. I must admit I’ve never heard of this one before.
    The failed states index

    It will be interesting to monitor how this type of index might evolve in years to come. Beauty can fade, at least the superficial type we can see, although inner beauty is more important, right?
    In the beauty contest of countries and currencies, it will be interesting to observe what lies beneath the surface if scraped.

    The aim of the index is interesting:
    We encourage others to utilize the Failed States Index to develop ideas for promoting greater stability worldwide. We hope the Index will spur conversations, encourage debate, and most of all help guide strategies for sustainable security.