The AUD is not your friend | FT Alphaville

The AUD is not your friend

Well, not if you are short the AUD because of all that hard landing business. Or, if you are an Australian exporter.

The Australian dollar has long been seen as a China/commodities trade, but Macquarie’s Brian Redican reckons that’s no longer the case. The currency is increasingly influenced by external factors, rather than the country’s own ever-growing mining sector, or its monetary and fiscal policy.

And this, he says, is a momentous shift — so much so that Macquarie now sees the AUD remaining around its current levels for several years, and only gradually sliding to $1.05 by 2015. Their previous forecast was a fall below USD parity by the end of this year.

Those external factors will sound familiar:

While there are several explanations for this performance, Australia’s rock solid AAA credit rating, relatively high interest rates and more interest from official investors, such as central banks and sovereign wealth funds are generally considered to be important.  Moreover, aggressive “quantitative easing” from major central banks may have intensified these pressures.

It’s now reached the point where 75 per cent of national government bond issuance is held offshore. And yields are high against other AAA sovereign bonds: close to 4 per cent for 10-year maturities.

Redican says that, ever since QE2, modelling the Australian dollar on commodities prices and domestic monetary policy just doesn’t cut it anymore:

The escalation of quantitative easing in the second half of 2010 appears to have been so decisive in breaking the model because it pushed down Australian bond yields (which should traditionally have been reflected in a lower currency) even as the RBA warned of rate hikes, while at the same time prompted investors to reallocate funds to the A$.  Finally, the positive impact on commodity markets was not as great as QE1.

If, however, we augment this simple model with some additional factors, such as the proportion of bonds held offshore and the current account deficit adjusted for imputed dividend payments, then the model tracks the A$ much more closely over the recent period (see Figure 4).  Thus, this does seem to suggest that there has been a significant change in the drivers of the Australia in recent years.

AUD models -- commodities versus other factors. Source: Macquarie

And it’s likely to continue:

Of course, some analysts have suggested that because such a high proportion of the bond market is now owned offshore, the only way is down. And that means that this positive boost to the A$has now run its course. In our view, this argument is unsatisfactory as it suggests that a strong government balance sheet (ie falling debt) will result in a weaker currency (as there are fewer bonds to buy).

The problem is that at least some of those foreign investors (well, the SWFs at least) could just increase their holdings of other AUD-denominated assets, such as farms. Or they could expand into semi-government bonds (which are rated a notch below triple-A and have correspondingly higher yields, despite being effectively backed by the federal government). Either way, the AUD is supported.

The RBA has noted this, but has signalled it is setting the bar very high for any intervention. And indeed, unemployment is low and inflation is within its target range.

That may change, however, he says:

If it is correct that the A$ is now driven as much by offshore investor portfolio flows as it is by domestic fundamentals, then it also signals a momentous shift in how analysts should think about the A$.  Certainly in 1997-98, 2000-01 and 2008-09 the A$ played a key “shock absorber” role for the domestic economy during difficult periods.  Now, however, it may well be that it is the currency that is forcing change on the economy, rather than helping the adjustment.

For that reason, it is worth pointing out that the upgrades to the A$ do not reflect a more upbeat view of the domestic economy.  Rather, it is potential for the A$ to remain higher for longer that is one factor underpinning our caution on domestic growth.

In our view, however, the current level of the A$ is not consistent with the economy remaining near full employment.  The A$ is clearly damaging large parts of industry, and the longer it remains high, the more damage it will do. Our expectation that the currency will remain high should not, therefore, be viewed as validating its current level.

That’s not unthinkable either — Macquarie, incidentally, thinks the current situation of near-full employment is not supported by the AUD being strong for longer. And as Neil wrote this week, it’s not helping the Australian stock market either, whose performance of late has been woeful against those of other developed economies. There was apparently talk among forex traders last month that Australian corporates themselves were buying AUD, suggesting they were already nervous of the scenario Redican has outlined.

It’s a rather awkward place for an economy to be.

Related links:
How to save us from the Australian dollar – Macrobusiness
The Changing Structure of the Australian Economy and Monetary Policy
– Speech by RBA deputy governor Philip Lowe