How low can the Aussie dollar go?

There are five key influences on the Australian dollar and each offers a clue as to how low the dollar might fall.

It’s now almost 30 years since the float of the Australian dollar and rarely has it been stronger than in the past few years.

Only now are investors, surprised at the rapidity of the recent drop, waking up to this fact. The economy is starting to feel it too, with Ford closing down local operations, local tourism struggling as Australians head overseas and now Holden giving an ultimatum to staff: accept pay cuts or risk losing your job.

Many people explain away this strength with the phrase ‘‘commodities boom’’, but it’s more complex than that.

There are five key influences on the Australian dollar and each in its own way offers a clue as to how low the dollar might fall.

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1. Interest rates

If you can borrow at 0.25 per cent in Europe, the US or Japan and can invest it in Australian bonds, assets or bank accounts paying 3-4 per cent, plus capital gains, why wouldn’t you?

National Australia Bank recently estimated that the upward pressure on the local currency as a result of the US Federal Reserve’s zero interest rate and their quantitative easing program could be worth as much as 20 cents in the Aussie.

And of course, those global investors could look at the Reserve Bank and feel pretty safe that if it were to reduce rates, it would do so cautiously and gradually.

For the last few years, Australia has been a giant post box for international hot money. Right now, that reputation is under pressure.

2. Global and Australian growth

In addition to relatively high rates, global investors flocked to Australia after 2009 due to the resilience of the Australian economy, assisted by local and Chinese stimulus.

We didn’t have a housing crash and we didn’t follow the US and UK economies into deep recession, which is why we became a safe harbour.

3. The US dollar

The US dollar is the most under-appreciated driver of the Aussie dollar.

Traders and investors talk about growth, interest rates, the mining boom, the budget position and household debt, but on the other side of the AUD/USD currency pair the same questions are asked of the US as an input into the Aussie.

The perceived value of the US dollar is an important factor in the relative price of the Aussie and, after a long period of weakness, it’s likely to grow in strength.

4. Investor sentiment

When we see a convergence of major drivers like this, investor sentiment itself becomes a fourth driver. Here, we enter the currency expectations market.

Since 2009 large speculators – hedge funds and the like – have been supporters of the Aussie dollar for all but a brief period of market instability in the middle of last year when the euro teetered.

Generally, global speculators have been supporters of the Australian dollar since the global financial crisis. That is now on the verge of a reversal.

5. Technicals

The Aussie has had strong technical chart since the GFC: every new move led to a new high and every dip was followed by a rebound. Even as volatility reached extreme levels in the past few years, the chart for the Aussie remained indomitable. Its safe-harbour status was never breached in a technical sense. That encouraged speculators and investors to buy the dips whenever global trouble loomed.

That’s how we got to where we are. To see where we might go, let’s examine these five key drivers from the other angle.

Australian interest rates are falling much further than most forecasters anticipated. The main cause is that Chinese growth is slowing faster than many expected (although not us), pushing down the key export prices that drove Australia’s commodity boom. As a result, mining projects have been cancelled en masse. Yet the boom ran long enough for mining companies to believe it would last.

Even with the cancelled projects, lots of new supply is on the way, just as China slows. This will drive commodity prices down further still.

The likelihood is that Chinese and Australian growth, and Australian interest rates, will fall further. So although the carry trade into the dollar is still positive, with declining yields and an increased risk of capital loss, it now faces more headwinds.

To make matters more difficult for the Aussie, the US housing market is recovering. Although fiscal challenges loom and monetary policy is still very loose, markets are beginning to price in stabilisation to the former and a tightening in the latter.

In the passing beauty parade of foreign exchange, the US dollar is being viewed as the least ugly. As the US dollar index rises it is hitting a variety of asset classes, including gold and the Aussie dollar.

Sentiment among hedge funds and speculative traders – see recent comments by George Soros and Stanley Druckenmiller – has turned against our currency.

As recently as April this year, the Aussie was trading above $US1.05 before the recent fall took it to around $US0.92. That’s a fall of about 12 per cent.

So, how low can it go?

NAB recently suggested the $A could fall to 87 US cents by December 2014. But let’s remember that for all the extreme recent calls about the crash in the Aussie and the impending doom facing it, the reality is that it is simply back at the bottom of what might be considered a wide 10-15 cent range it has been in since breaking up through 94 US cents in mid-2010.

This sell-off is not all that shocking and the forecasters of doom forget this.

A fall below 94 cents would signal a different and lower scenario. Our assessment is that this is likely, especially if the economy weakens due to the withdrawal of mining investment, assuming consumption doesn’t fill the gap.

That may necessitate rate cuts to 2 per cent or just below.

Despite the recent highs, the Aussie dollar’s average remains steadfastly around 75 US cents. It may not revert to the mean but after 22 years without a recession, you wouldn’t want to bet on it.

What might happen if Australia did have a recession?

The answer was offered during the GFC low when global investors believed that was about to happen. Back then it fell to $US0.5960. There’s your answer.

To protect your portfolio against that possibility, and to hedge against falling interest rates, Intelligent Investor Share Advisor has recommended allocating a portion of your portfolio to overseas markets. Each of its model portfolios has an allocation to businesses that stand to benefit from a falling Aussie dollar.

This article contains general investment advice only (under AFSL 282288).

By Greg McKenna and David Llewellyn-Smith of MacroBusiness, in conjunction with Intelligent Investor Share Advisor, shares.intelligentinvestor.com.au.

Read more: http://www.smh.com.au/business/how-low-can-the-aussie-dollar-go-20130624-2osff.html#ixzz2XB3rOnK3