Yield Advantage
Beginning 2014 trading around $0.89, the Australian dollar remained remarkably resilient throughout the first half of 2014, reaching highs of $0.95 at the beginning of July, buoyed by a yield advantage over its global counterparts as the Reserve Bank of Australia (RBA) moved their policy bias from negative to neutral. Repeated efforts by Glenn Stevens and his colleagues at the RBA to weaken the domestic currency in order to achieve economic growth targets were met with fierce resistance by market participants who continued to dismiss the possibility of interest rate cuts. The Aussie dollar continued to remain attractive when up against its low yielding counterparts across the globe, resulting in record investment flows into Australian dollar denominated products, particularly from Japan.
It wasn’t until September that the Aussie dollar began playing catch up with slowed mining investment from China which has resulted in the sharp fall in iron ore prices, Australia’s most valuable export. Demand from China began to falter in mid-2011 but the dollar remained comparatively resilient, losing only a fraction of the amount wiped from commodity prices. Many began to question how long the Aussie dollar can remain at elevated levels, an exchange rate that the RBA perceive to be unsupportive of economic growth and a burden on the nation’s transition from a mining led economy.
Weaker than expected US non-farm payrolls for August saw the Aussie dollar break to yearly highs of $0.94 in early September but things were about to change. Calls from San Francisco Fed officials that markets are underestimating the likelihood of a near-term interest rate hike came in a string of events that raised expectations of when the Fed will begin to lift interest rates. Weaker demand for commodities from a slowed Chinese economy, uninspiring domestic data and repeated calls from the Central Banks of Australia and New Zealand warning investors of unsustainable strength in their respective currencies, all contributed to Aussie dollar weakness when up against a broadly stronger greenback.
The RBA’s Next Move
Whilst opinions are vastly different depending on which bank you ask, most would agree that a rate hike is off the cards until at least Q3 of 2015, which gives the RBA time to observe spare capacity in the labour market, substandard wage inflation and a slowing Chinese economy. But there are a growing number of financiers who don’t foresee a rate hike as the RBA’s next move.
The RBA have not been shy in their efforts to weaken the Australian dollar but their success was limited and their own efforts repeatedly failed to achieve their idea of ‘fair value’ of $0.85 against the greenback. However, through no efforts of their own and largely due to a broadly stronger greenback, their target level is fast approaching and recent moves have somewhat eased pressure from central bankers to intervene if the exchange rate was to remain at elevated levels. However, it remains to be seen whether the RBA will judge recent weakness in the Australian dollar as sustainable and supportive of economic growth, or whether and additional rate cut will be required.
Managing a rate cut in an environment of overheating domestic house prices would prove to be difficult, hence the RBA hinting towards ‘macroprudential’ policy – essentially applying tougher rules on home loans to banks who have adopted risky lending practices in a low interest rate environment.
If the RBA is to adopt ‘macroprudential’ measures which turn out to be successful, there is a case to suggest that further rate cuts are a possibility, particularly as housing inflationary pressure would be somewhat contained, therefore opening the door for loosened monetary policy to spur growth. Rising unemployment, declining consumer spending and slowed non-mining capital expenditure intentions (capex) are all likely to subdue inflation therefore giving the RBA room to remain accommodative with monetary policy. However, the onset of asset purchases across the Eurozone and further monetary easing in Japan could lead to an influx of funds in high yielding Australian fixed income and give the RBA no option but to cut interest rates in order maintain ‘fair value’ in the exchange rate.
Few would argue that the US will be the next developed economy to lift interest rates given the pace at which their economy has recovered, particularly now as a 6-year monetary easing programme (QE) has come to an end. Higher US interest rates would reduce the disparity between Australian and US yields and could well result in an exodus from Australian dollar denominated assets. However, it remains to be seen whether fair value will be achieved naturally as a result of increased global interest rates, or whether it will require the RBA to intervene. Whilst the door remains wide open to further rate cuts in the transition away from a commodity driven economy, the RBA might have played their cards right in achieving fair value, without cutting interest rates further and leaving the local currency to the mercy of higher interest rates around the globe.

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