Economic and Financial Market Update: Money And The $A

Summary:

• The $A has fallen from over US80c in early 2018 to be now trading in the high US60c;

• The weaker currency is helping to support the Australian economy;

• The main reason for the weaker $A is lower domestic interest rates;

• The majority of analysts expect a higher $A in 12-months’ time;

• Whether this happens will be determined by how the economic outlook evolves.

‘Money, money, money

Must be funny

In a rich man’s world’

‘ABBA’

You know a band is truly iconic when thirty years after their last hit they can still fill the dance floor. And by any standard, ABBA is one of those bands. It is estimated they sold over 380 million records (does everyone still know what they are), and had eight number one albums. Dancing Queen was probably their biggest hit, but Money, Money, Money was right up there.

One of the images often associated with Money is the foreign exchange market. The exchange rate plays an important role in the economy, particularly in a relatively small one such as Australia. A change in the exchange rate shifts the price of Australian-produced goods and services relative to world economy goods and services. Directly that change in price impacts Australia’s inflation rate. But a lower exchange rate (for example) makes Australian goods and services cheaper, boosting demand from overseas (a plus for domestic production and employment).

Which is exactly what has been happening. The $A has fallen from over US80c in early 2018 to be now trading in the high US60c, around its lowest level in ten-years. Part of the reason is that the $US is strong. But the $A is also well below its long-term average value against the yen and (interestingly) the $NZ. The $A is trading close to its average level against the Euro and the Chinese Yuan. The $A is strong against the UK Sterling, where the impact of Brexit is being felt. Overall, the $A (weighted by trading partners) has declined by around 10% since the beginning of 2018, and is currently around its long-term average.

As expected, the lower $A has had beneficial economic impacts. The trade balance is at its highest level (relative to the size of the economy) since the 1970s. Partly that reflects high iron ore prices and the completion of large gas projects. Weak consumer spending is holding down the importing of consumer goods. But the weaker $A has helped boost demand for manufacturing goods, with manufacturer’s having a relatively positive view on the export outlook.

What factors have driven the $A over the past year? One consequence of Australia being a major commodity exporter is that the $A is impacted by changes in commodity prices. The commodity prices that are important to Australia (such as iron ore) were rising from early 2018 to mid this year (although iron ore prices have declined sharply over the past couple of months). A measure of the underlying demand for Australian dollars is the Basic Balance of Payments (BBoP, essentially the current account balance plus foreign direct investment). In line with the high Trade surplus, the BBoP is at its highest surplus since the early 1970s, indicating a strong demand for $A.

The main driver for the weakness of the $A is the very low level of Australian interest rates. Australian two-year interest rates are at their lowest level relative to US two-year rates in over 20 years, and at least 40 years against Japanese two-year rates. Australian and New Zealand two-year yields are currently around the same level (usually New Zealand yields are above Australian yields). While Australian yields are at their lowest level relative to Germany in a decade, movements in the Euro can be impacted by developments in other countries (such as Italy and Greece). The relatively lower level of Australian interest rates to global rates has reduced the inflow of overseas money. For example, the amount of foreign deposits in $A has fallen from its peak by around 10% over the past couple of years.

A basic fair value model (one that contains the terms of trade, difference in two-year interest rates and the Basic Balance of Payments for both the US and Australia) had the $A trading around its fair value level against the $US in the June quarter (the more recent fall in iron ore prices would result in that range currently being a cent or two lower). A recent survey from Refinitiv indicates that a large majority of analysts expect the $A to be higher in twelve months. That likely reflects most analyst views that lower global interest rates will not only see the world economy improve, but boost the interest rate differential in favour of the $A.

One outcome of lower domestic interest rates is it has resulted in a weaker $A. The $A is currently both trading around its long-term average against its major trading partners and is close to its ‘fair value’. The weaker currency is helping the economy. If the economy outlook improves, a stronger $A is likely in line with the consensus view. But if economic outlook deteriorates the clear risk is that $A will fall towards 65c. ‘Take a Chance on Me’ was another of ABBA’s many hits. Taking a chance on the $A will (mostly) depend upon your confidence in the economic outlook.

We live in interesting times!

Peter Munckton - Chief Economist