New pressures for the almighty Australian dollar

It looks like the long overdue and often remarked upon depreciation of the Australian dollar has started.

It has dropped by around 4 per cent in the last month, not only against the US dollar, but on the trade weighted index which is a basket of global currencies calculated by the Reserve Bank of Australia.

The TWI is the best measure of the Australian dollar as it captures the impact of the changes in value of our dollar against the euro, yen, renmimbi, won, rupee, pound and a bunch of other currencies.

From a level of 80.2 index points on April 12, the TWI fell to 77.1 points at 1600 AEST yesterday and based on the fact that the Australian dollar has slipped a little since that calculation was made, it is likely to be under 77 index points this morning (note the Reserve Bank only calculate the TWI at 1600 AEST each day).

Against the US dollar, the fall has been from a recent peak around 1.0550 to this morning’s level around 1.0165.

There is no doubt the Australian dollar is still overvalued. It looked to be nearer fair value earlier this year as global conditions seemingly improved, commodity prices kicked back higher and the central bank had all but finished its interest rate cutting cycle, or so it seemed. I was certainly upbeat about the prospects for the Aussie thinking 1.10 or even 1.20 in the long run was possible as the global economy recovered.

This optimism has been dashed with global economic conditions taking a turn for the worse, most notably with the cooling of activity in China and the US, but also another leg lower in the European depression. So bad is Europe that disinflation risks becoming deflation, the unemployment rate is above 12 per cent and the European Central Bank is contemplating negative interest rates.

The US is a little better, but there are growing concerns about the sustainability of its recovery. Just last week, the US Federal Reserve left open the possibility of adding to its $US85 billion a month of bond purchases if the downside economic risks it spoke about came to fruition.

These downside pressures in the global economy do not bode well for the Aussie dollar.

Even with the recent small fall, the Australian dollar has not tracked the fall in commodity prices lower. The Reserve Bank of Australia’s own index of commodity prices, in US dollar terms, have fallen 22 per cent in a little over 18 months yet the Australian dollar is only a few per cent below the level it was when the commodity price peak was reached in the middle of 2011.

Had the general correlation between commodity prices and the level of the Australian dollar held, in an approximate terms, it would be trading below 90 US cents now, perhaps well below.

The reasons remain reasonably straight forward for the sustained overvaluation.

In a world still reeling from the fallout of the banking, housing and sovereign debt crisis, investors are placing a premium on low risk assets.

At a conference I was at yesterday with Westpac’s chief economist Bill Evans, he mentioned Australia being a safe-haven for global investors should there be a rerun of the global crisis or even a mild version of it. He also was strongly of the view that the budget next week would pose no threat to Australia’s unsurpassed reputation as a low debt economy. While Bill was of the view the dollar would fall to around 96 US cents in 2014, he also reckoned that even if the government’s net debt doubled (which no one is forecasting by the way), the credit rating agencies would remain positive about Australia’s financial position and maintain the triple-A rating.

With Australia locking in a triple-A credit rating from all three agencies (Moody's, Standard & Poor's and Fitch), our bond and stock markets are a standout for foreign investors. It is increasingly clear that Australia is, for now at least, a safe-haven investment destination in a sea of high level risk.

The status as a reserve currency or even quasi reserve currency sees these investors buy and hold and buy again Australian dollar denominated assets.

Those positives aside, it remains the case that the recent fall in the Australian dollar is the start of things to come. Commodity prices remain soft, global growth fragile and local inflation is very low. The central bank is likely to cut interest rates again in coming months which should, at the margin, take a little support away. Bill Evans might be right to think that 96 US cents is a target for 2014, but history shows that when currencies break out of trading ranges, they tend to move quickly and go further than even the best forecasters expect.