Where to from here for the Aussie dollar?

From April 2011 till April 2013 the Australian dollar was above parity against the US dollar. Since then it has had a steady decline to the low 70c's. This has occurred due to declining commodity prices, declining A$ interest rates, the prospect of increasing US$ interest rates and the risk off trade.

Purchasing power parity (PPP) for the A$ is around the mid to high 60c's. Whilst the PPP is a very inexact predictor of exchange rates in the short term, over the long term it often is a good predictor.

AUD chart 

What factors have led to the decline in the Australian dollar?

Whilst commodity prices have declined significantly they continue to be under pressure, with the possibility of further movements down in coal and iron ore prices. Combined with pressure on oil and gold prices, this is unlikely to be a support to the A$.

In terms of interest rates the gap between US and Australian interest rates has narrowed substantially over the last few years thus the 'carry' trade is nowhere as relevant as it used to be and any increase in US interest rates will further narrow it.

After such a large decline in the Australian dollar, it is reasonable to ask where to from here?

Most of the analysis of the A$ decline has been against the US$. Against some other currencies, however, the fall has not been anywhere near as dramatic. This reflects the fact that some of the fall is more related to the US$ strength rather than just A$ weakness.

As we know currencies, like many asset classes, are never perfectly priced and as such will overshoot on both the upside and the downside. There is a very real possibility that the A$ declines into the 60c's against the greenback in the foreseeable future.

Back in 2002 the A$ reached a nadir of 48c against the US dollar, though interest rates were much higher then than now. Commodity prices were lower in most cases but they are heading back to the earlier lows and it is quite conceivable that they reach those lows again. If this occurs, combined with low interest rate support and a strengthening US dollar, a very low A$ is possible.

The lower A$ is already having a positive impact upon tourism, education services, agricultural exports and helping to maintain the viability of mining exports despite lower prices denominated in US$. All these factors will tend to stabilise the A$ over time and eventually lead to some sort of rebound, but it will need time to play out.

Another aspect of the low A$ could be higher inflation from the traded goods sector, but with low commodity prices and the lack of a transmission mechanism to wages it is unlikely that it would lead to any sustainable increase in inflation.

As the lower exchange rate is doing a lot of the heavy lifting for the Reserve Bank and the Federal Government (a luxury Greece does not have) there is likely to be continued downward pressure on the exchange rate by policy makers – and there is an old saying in investment markets – don't fight the Fed. Or in this case, don't fight the Reserve Bank.

The practical investment implications are that in the short to medium term we remain unhedged because there is still further potential downside in the A$, the carry trade has largely dissipated and the natural hedge of being unhedged on offshore assets (ie when overseas equity prices go down so does the A$ - thus providing a natural hedge).

If the A$ overshoots too much – say to the low 60c's or 50c's – we will likely re-instigate comprehensive hedges over our offshore assets.

The other aspect of the low A$ is that in the Australian equity space offshore earners become a lot more attractive and this is then reflected at the stock picking level of the Australian equity portfolios.

The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.