Dr Shane Oliver | AMP
Currency markets are well known to be volatile – as there is no clear agreement on how to value them and they are vulnerable to international shocks and shifts in investor sentiment. Changes in the value of the Australian Dollar are important as they impact Australia’s export competitiveness and the cost of imports, including that of overseas holidays. For investors they directly impact the value of international investments and indirectly impact the performance of domestic assets via the impact on competitiveness.
Unfortunately, currency forecasting is a bit of a mugs game to which John Kenneth Galbraith’s observation in relation to economic forecasters that there are “those who don’t know and those who don’t know that they don’t know” may apply.
So, it should not be surprising the value of the Australian Dollar continues to surprise. Six months ago, when the Australian Dollar rose to $US0.67, we thought it would go higher for various reasons including that it was slightly undervalued and interest rate differentials looked likely to shift in favour of Australia. As it turns out it did go higher, rising above $0.69 in September. But then it fell sharply, recently reaching a low of $US0.615.
This in turn has led to concern about a boost to inflation and the RBA being less able to cut interest rates and possibly having to raise rates. This note looks at what’s driven the fall, the outlook and its implications.
The fall in the value of the Australian Dollar reflects a combination of three things:
Source: Bloomberg, AMP
So, the fall since September is mainly a strong US dollar story rather than a weak Australian Dollar story as since September the Australian Dollar fell around 10% but the US Dollar rose around 9% as other major currencies also fell against the US Dollar.
It’s not the RBA’s role to defend the Australian Dollar or maintain it at a particular level - otherwise it would defeat the whole purpose of having a flexible exchange rate which is to provide a shock absorber to events that threaten our growth outlook – like less demand for our exports. But it’s fall will be of some concern to the RBA in terms of the risk that it poses to inflation as a fall in the value of the Australian dollar by boosting import prices could add to inflation. However, there are several reasons why the RBA is unlikely to be too concerned.
It’s worth noting that the $A plunged in 2001 (to $US0.48); 2008 (from $US0.98 to $US0.60 in 3 months) and in the pandemic (to $US0.57) and yet the RBA eased on each occasion with other factors dominating!
In short, while the fall in the $A will concern the RBA we don’t see it as being enough to stop the RBA from cutting rates ahead. Ultimately, the rates decision next month will come down to December quarter inflation data to be released next week. If trimmed mean inflation comes in at 0.6% quarter-over-quarter or less as looks likely as against implied RBA expectations for a 0.7% quarter-over-quarter rise, it will be very hard for the RBA not to cut in February.
Firstly, from a long-term perspective, the Australian Dollar remains cheap. The best guide to this is what is called purchasing power parity (PPP) according to which exchange rates should equalise the price of a basket of goods and services across countries (the red line in the next chart). If over time Australian prices and costs rise relative to the US, then the value of the Australian Dollar should fall to maintain its real purchasing power and vice versa if Australian prices fall versus the US.
Consistent with this, the Australian Dollar tends to move in line with relative price differentials over the long-term. Right now, it’s cheap at around $US0.63 compared to fair value around $US0.72 on a purchasing power parity basis.
Second, sentiment towards the Australian Dollar is negative, reflected in short or underweight positions. Many of those who want to sell the Australian Dollar may have already done so and Trump’s return may already be factored in, and this leaves it susceptible to a rally if there is any good news.
Finally, commodity prices look to be embarking on a new super cycle. The key drivers are the trend to on-shoring reflecting a desire to avoid a rerun of pandemic supply disruptions and increased nationalism, the demand for clean energy and increasing global defence spending all of which require new metal intensive investment compounded by global underinvestment in new commodity supply.
In the short term, the Australian Dollar is bouncing from oversold levels (and the US Dollar
falling from overbought levels) as Trump’s return was largely factored and so far his bite has been less than his bark.
Over the next 12 months, it’s likely to be buffeted between changing views as to how much the Fed will cut relative to the RBA and how far Trump goes on tariffs (so far so good – but there is a way to go yet as Trump is still saying tariffs are coming) versus potential positives of undervaluation, negative sentiment and maybe more decisive stimulus in China. This could leave it stuck between $US0.60 and $US0.70, but with the risk skewed to the downside if Trump acts more aggressively on tariffs.
While the fall in the value of the Australian Dollar will add to the cost of petrol and overseas travel (mostly to the US) and could constrain the RBA in cutting rates, although we don’t think this will be significant, there is a silver lining to the cloud in that the fall has boosted the value of (unhedged) international assets so it has enhanced returns in global shares.
This highlights the benefits of having a well-diversified investment portfolio across both assets and also across currencies.
All prices and analysis at 21 January 2025. This document was originally published in 21 January 2025. This information has been prepared by AWM Services Pty Ltd (ABN 15 139 353 496)(AFSL No. 366121), part of the AMP Group. The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. Past performance is not a reliable indicator of future performance. Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB. Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.