WEEKLY E-MAIL

7 August 2017

THE AUSSIE DOLLAR SURPRISE

By James Malliaros

The Australian dollar’s (AUD) strong rally in recent weeks has caught the market by surprise and signs show that it could push higher – possibly even hitting US$0.85. That’s potentially a big jump compared to current levels at around US$0.7950 and just US$0.74 back at the start of June.

The strength of the currency reflects a few main factors:

• First, the AUD has been pushed higher lately by both a weaker US dollar (USD) and a rebound in commodity prices.
• Second, increasing chances of a rate rise in Australia on the back of economic strength.
  Retail trade data for May surprised the market by rising 0.6% after a 1% gain in April and the strong rise in full-time employment in the June Labour Force Report helped reinforce the current strength of the domestic economy. Other indicators such as business confidence, job advertising and house prices all suggest the Australian economy is emerging out of the mining downturn in good shape.
  Saying that, we don’t expect the Reserve Bank of Australia (RBA) to increase interest rates any time soon, with the market now not expecting a hike in rates until the middle of next year.
• Finally, global growth continues to be resilient which supports the China story. China has released some unexpectedly upbeat data, including Q2 GDP figures, which has prompted an increase in the price of industrial metals.

Despite the relatively high dollar, in a big picture sense it’s not out of whack with long-term fair value based on relative prices or what is referred to as purchasing power parity. This can be seen in the chart below, which shows where the AUD should have been over time if it had moved to equilibrate relative consumer price levels between the US and Australia.

Source: RBA, ABS, AMP Capital

The RBA has however made it clear it would like the currency lower given the significant risk it poses for the Australian economy, which can constrain growth and keep inflation below target for longer. Direct intervention by the RBA to lower the currency would probably not be a realistic option at this stage given the large cost involved in selling high-yielding AUD assets for lower-yielding foreign assets in the pursuit of a weaker AUD.

Similarly, reducing interest rates further would also not be an option unless the domestic economic outlook deteriorated, but this is not in the RBA’s forecasts.

The rally in the AUD vs the USD isn’t yet a concern for the RBA’s relatively positive view on the Australian economy, but it would help if it was trading closer to US$0.70. Similarly, it would also help the global outlook if the US economy could absorb a stronger dollar.

The main channel the currency impacts on the domestic economy is through business profitability and the flow-on-effects of job creation. Traded industries such as mining, manufacturing, agriculture and services like tourism and education all benefit from a weaker AUD.

While the AUD could still go higher in the short term, it is likely to break back down at some point in the next year as the USD bounces back, upside to commodity prices is reduced and the interest rate differential in favour of the AUD narrows as the US Fed hikes interest rates and the RBA holds.

For investors, this means there remains a strong case to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars as they will go up in value if the AUD falls.

James Malliaros
Senior Financial Planner
SMSF Specialist Advisor™
Authorised Representative No. 291633

If you have any questions or comments, please email me at james@gfmwealth.com.au

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