“In my view, as long as global uncertainty and problems in Europe and, to an extent, the US persist, the behaviour of the Australian dollar (AUD) is unlikely to change significantly.

“I also believe that the domestic economy is on a slower growth path as it continues to adjust to a high AUD and the RBA is setting monetary policy to accommodate this period of adjustment.

“In the short term we will experience lower official interest rates as the rest of the world continues to de-lever and the continuation of foreign quantitative easing (QE) programs keep the AUD strong.

“The currency will most likely continue to remain strong in the near term, which should restrain inflation, allowing the RBA to keep interest rates at these lower levels.

“However, in the longer term, as the AUD stabilises and the economy continues to adjust to accommodate it, the effect of the AUD on containing inflation will wear off (as it began to in the December quarter of 2012).

“For interest rates to remain low, inflation (and the outlook for it) needs to remain stable. This either requires domestic inflation to fall or the AUD to not depreciate. If the strength in the AUD is a direct result of overseas QE programs, we could see the official cash rate rising as these programs reverse and the upward pressure they are exerting on the AUD starts to dissipate,” Mr Bridges said.

He said that for the time being, the main drivers of the strong AUD show no sign of disappearing. These drivers include:

• Australia remains one of the few remaining countries with a stable AAA rating.  Even the US has lost its coveted AAA status, with many other major economies on a negative outlook. This creates demand for Australia’s relatively ‘safe’ assets.
• By running deficits during the GFC, the Australian government has effectively re-established a large and deep government bond market.  This extra supply may have created its own demand as more central banks look to the AUD as a currency to diversify into, while they reduce their weights in the US dollar (USD) and Euro.
• The effect of the mining capital expenditure boom is another factor in the AUD’s strength.  A recent research paper from the RBA highlights that net foreign investment into the resources sector increased from 0.5 percent of GDP in 2007 to 3 percent in 2012. This foreign direct investment in the mining sector to fund new projects has exerted upward pressure on the AUD.
• Many of the world’s central banks have used QE to stimulate their country’s weak economy, hoping to push investors into equities and riskier assets than government bonds as they search for greater yield. Essentially, this means that the bank increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity. Another objective of this policy is to weaken the home country’s currency.  For a country like Australia that has a floating currency and is not itself engaging in QE, the result is that its currency appreciates as these policies unfold.

“The easier monetary policy from the US, and now Japan, is essentially being imported into Australia’s economy, pushing up our currency.

“Although Australia has an independent monetary system, the rising currency can still result in easier monetary policy here.  Exchange rate sensitive sectors are suffering as the currency remains strong, making them less competitive than peers in countries with a weaker currency.

“In addition, the stronger dollar helps to keep top-line inflation subdued, which has allowed the RBA to cut official interest rates over the last year or so.  While domestic inflation has not fallen, international or tradeables inflation has plunged due to the strong currency, dragging down the headline inflation figure and keeping inflation within the RBA’s target band.

“In fact, domestic inflation is still very high, being above the RBA’s two to three percent inflation target. 

“Furthermore, the effect of the stronger dollar on tradeable inflation is starting to wane and there has been a marked pick up over the past six months. This may be due to improvements in domestic productivity as the economy adjusts to the ‘new normal’ rate of the AUD.

“However, domestic consumer and business confidence levels are at historical low levels and, in some cases, are worse than in countries experiencing much greater economic problems.

“Some of this can be explained by the bad news from overseas and the fact the Australian economy is going through a structural rebalancing, which is causing uncertainty.

“Much of the structural change is due to the strong AUD forcing businesses to readjust to accommodate it and improve productivity,” Mr Bridges said.

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The Aussie dollar lifted to US104 cents after the latest data, providing complications for the Reserve Bank. The trade weighted index is only 3 per cent below record highs.

What does it all mean?

• By all means Australia would prefer a strong Chinese economy as opposed to a weak economy. But the latest sign of recovery in the Chinese economy carries a sting in the tail. The Chinese manufacturing sector is picking up momentum, suggesting increased demand for raw materials such as iron ore and coal. But firmer demand for raw materials, also suggests stronger demand for the Aussie dollar. And that stronger currency will make life tougher for a raft of Australian industries including retailing, manufacturing, tourism and export industries more broadly.
• The firmer Aussie dollar creates challenges for the Reserve Bank. If the Aussie dollar does indeed trend higher in line with higher demand and prices of raw materials, then there is no issue, that’s what the currency is expected to do. But if the Aussie rises further and faster than commodity prices then it represents a tightening of policy settings.
• About the only groups celebrating a firmer Aussie dollar would be consumers (buying goods online) and travellers (cheaper overseas trips).
• Financial markets believe that there is a 61 per cent chance of a rate cut in December. Australian economic data has been soft, while the Aussie dollar has remained firm – the two factors arguing for a December rate cut. The offsets are stronger Chinese and US economic data. So it seems another coin toss whether the Reserve Bank cuts rates in December or holds off until the New Year.
• CommSec is pencilling in a rate cut in February 2013. But the issue of an early rate cut is clearly “live”.

What do the figures show?

• The HSBC “flash” Purchasing Managers Index for China lifted from 49.5 to 50.4 in November. Any reading above 50 suggests the manufacturing sector is expanding. It was the highest reading for the PMI in 13 months.
• The “flash” China manufacturing output index rose from 48.2 to 51.3.
• The survey data was collected from November 12-20. The final November reading will be published on December 3.
• HSBC notes: “The HSBC China Report on Manufacturing is based on data compiled from monthly replies to questionnaires sent to purchasing executives in over 420 manufacturing companies. The flash estimate is typically based on approximately 85-90 per cent of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data.”

What is the importance of the economic data?

• “The HSBC Flash China Purchasing Managers’ Index (PMI) has been created in partnership with Markit to provide the earliest indication of economic conditions in China.” The data is published a week ahead of the final PMI data every month.” The data has implications for Australian resources companies and the Aussie dollar.

What are the implications for interest rates and investors?

• The latest economic data from China is encouraging. Not only is it encouraging for China, but also for Australia and the globe generally. The low point in the cycle appears to have passed, and further recovery is expected in China in 2013.
• Further good economic news from China and the US will put upward pressure on the Aussie dollar. The US economy is gaining momentum on gains in housing and export sectors. If (when) the fiscal cliff issue is solved, there are few other negative issues to take its place.
• We expect the Aussie dollar to be around US104 cents by end year and hover between US102-104 cents in 2013.
• A rate cut remains on the table. But the Reserve Bank needs to balance better conditions in China and the US with uncertainty about Europe, soggy domestic conditions and a firm Aussie dollar.

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• While capital flows associated with safe haven demand and foreign central bank reserve diversification have no doubt played a role in terms of recent $A strength, it is also easily consistent with the long term relationship to the terms of the trade, high relative interest rates in Australia and an improvement in confidence in global share markets over the last two months.
• As such, there is little justification at current levels for the RBA to directly intervene to limit the $A. A better approach would be for the RBA to continue lowering interest rates as this would help struggling cyclical sectors of the Australian economy and take some pressure off the $A.
• The $A is likely to remain strong over the medium term but the best of the gains are probably behind us.

To read this edition of Oliver’s Insights, click here.

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CommSec has analysed where the top 40 listed companies earn their money across the globe. Only 58 per cent of revenues from top 40 companies are generated solely from Australia. To read the full report, click here.

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Where to from here? Is the upswing from $US0.48 in 2001 now over?

The $A moves with other growth trades
In recent years short term swings in the Australian dollar have become highly correlated to other growth oriented risky assets like shares. This is clear in the chart below which shows the Australian dollar against the US share market.While the longer term trends in each differ (up for the $A, down for US shares) each time shares have taken a decent hit so too has the $A – falling 39% during the GFC, 13% during last year’s double dip worries and 14% recently. 

There are three key reasons for this sensitivity. First, because 70% of Australia’s exports are commodities the $A is seen as a commodity currency. Whenever there are concerns about global growth and shares take a hit, commodity prices also take a hit and so too does the $A.

Second, in times of economic uncertainty investors unwind so called ‘carry trades’. These involve borrowing in Yen or $US at near zero interest rates and parking the money in higher yielding currencies like the $A. When they are reversed during times of uncertainty, it pushes the $A down.

Third, the $US is seen as a safe haven currency (perversely given America’s debt problems). Since a big chunk of global trade and lending are conducted in US dollars, demand for them goes up in times of uncertainty. The $US strength in times of stress also pushes commodity prices down as most are priced in US dollars which in turn weakens the $A.

If anything this correlation with shares for the $A may intensify as more investors cotton on to the importance of macro economic issues in driving global investment markets and so see investing in terms of ‘risk on’ (buy shares, commodities and commodity currencies in good times) and ‘risk off’ (do the opposite).

Europe getting worse
It’s likely the $A’s vulnerability will remain high for some time. Europe looks terrible, with any relief provided by the EU’s latest policy response now being blown apart by political instability in Greece and Italy. While the EU’s latest response to its debt problems – of implemented – may help head off a worst case financial blow up it does nothing to break the vicious spiral of fiscal austerity, economic contraction, budget blowouts, market panic, more fiscal austerity, etc.

Current indications are that Europe is on track for recession. But it’s also driving social and political dislocation on an immense scale, as seen recently in Greece and Italy. Italy’s slide into the abyss since July is particularly worrying as it accounts for 17% of Euro-zone GDP and 23% of its public debt, and European banks have a near $US800bn exposure to it (as opposed to a $US130bn exposure to Greece). Italian elections will only lead to more uncertainty and delay. Italian bond yields have now reached levels that if sustained will turn its problems into a solvency crisis just like Greece. They have now surged past the levels that forced Ireland and Portugal to seek assistance.

The crisis is creeping further and further into the core of Europe with France also coming under pressure. The best way out of this would be for the ECB to commit to unlimited bond buying and significant monetary easing, but it is still not prepared to do this. What’s more there is increasing talk of a break up of the euro. All of which means continuing volatility out of Europe for some time to come, with an obvious threat to global growth, commodity prices and the $A.

From the short to the medium term
Pulling back from the myopic focus on the tragic soap opera unfolding in Europe and the short term vulnerability this implies for the $A, the medium term outlook for the Australian dollar remains strong. This reflects two key forces – long term commodity demand out of the emerging world and ultra easy monetary policy in the US, Europe and Japan.

Commodity story remains alive and well
While commodity prices have fallen sharply over the last few months the longer term trend remains up. Rising supply is likely to slow the uptrend in real commodity prices in the years ahead, but, abstracting from cyclical fluctuations, demand is likely to be strong, driven by rapid industrialisation in emerging countries.

Emerging countries are now passing through the $US3000-10,000 per capita income range that normally sees a sharp spike higher in demand for consumption goods. Last year, 50% of the population in emerging countries fell in this range.

Related to this, over the next few years around half a billion people in emerging countries will enter the middle class, adding to demand for consumer goods.

The potential raw material demand is highlighted in China. Despite massive investment, China still has a long way to catch up in terms of infrastructure and consumer goods. The following table compares China to the US.

On a per capita basis, roads, railways, phone lines, living space and cars are well below US levels. Indian levels are a fraction of China’s. This implies a huge catch up still ahead which is likely to continue to be driven by urbanisation, strong productivity growth and surging consumer demand – mainly in China, but increasingly in India.

As the catch up occurs it will result in increasing demand for commodities. The following table compares annual commodity consumption per person in China and India with that in Korea, Taiwan and the US.

 On a per capita basis, roads, railways, phone lines, living space and cars are well below US levels. Indian levels are a fraction of China’s. This implies a huge catch up still ahead which is likely to continue to be driven by urbanisation, strong productivity growth and surging consumer demand – mainly in China, but increasingly in India.

As the catch up occurs it will result in increasing demand for commodities. The following table compares annual commodity consumption per person in China and India with that in Korea, Taiwan and the US.

The historical experience suggests commodity consumption normally peaks once per capita income (adjusted for purchasing power parity) of $US25,000 is reached. However, China and India are well below this.  So as per capita income in these countries continues to grow, it implies a further significant increase in global commodity demand, particularly so given their 2.5bn population. India is running around 10 years behind China in terms of commodity demand but it has a similar demand potential in the decades ahead.

This all implies that, while Australia’s terms of trade may have peaked for this cycle following the recent fall in commodity prices, it is likely to remain at very high levels on a longer term basis, which in turn is likely to see the Australian dollar remain strong. In fact, even if the terms of trade just averages around current levels it implies the potential for more upside in the $A over the medium term.

 
Interest rates and monetary policy
While the RBA may be easing and may indeed ease further, other countries are also easing and likely by more. The public debt problems in Europe, the US and Japan – and resultant budget cutbacks and tax hikes – are likely to constrain growth in these countries for years to come.

This is likely to see interest rates stay near zero for at least the next two or three years. It is also likely to see further quantitative easing (ie using printed money to buy up government and other debt in order to boost the money supply). The UK started another round last month, Japan is continuing on a modest scale, the US is likely to follow in the months ahead and while the ECB professes it won’t, it probably will have to as Europe slides deeper into recession. The net outworking of all this will be to put ongoing downwards pressure on the value of the $US, Yen, Euro and British pound against other currencies. On the flipside, monetary easing in Australia is likely to be limited, reflecting the relatively stronger Australian economy. The end result will be that Australian interest rates will remain well above those available in traditional advanced countries (providing an inducement to park funds in Australia) and the supply of US dollars, Yen, euros and pounds will rise relative to Australian dollars – all of which will result in long term upwards pressure on the $A.

Conclusion
While the Australian dollar remains vulnerable to further weakness in the short term on worries about global growth, particularly on the back of Europe’s debt problems, on a medium term basis it is likely to remain strong on the back of emerging world commodity demand and relatively high interest rates and tight monetary conditions in Australia.

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