Much has been made of the Australian dollar’s (AUD) recent rally against the US dollar (USD). After spending much of 2016 and the first-half of 2017 averaging around $US0.75, the rally in the AUD to closer to $US0.80 in late June and early July has led the market to the question; what does a higher AUD mean for monetary policy and the broader economy?
But before we discuss the implications for the Reserve Bank of Australia (RBA) and the economy, it is important to consider what has driven this rally.
There have been a host of factors supporting the AUD, but the most significant one, has been USD weakness.
The DXY USD Index is down almost 10% from its December 2016 highs, led by declining expectations that President Trump will be able to deliver on his planned expansionary fiscal policies. The reduction in market pricing of these policies, has been felt in both bond and currency markets. This has sent the AUD, along with the EUR and JPY higher, but it is not the only factor that has driven the recent strength.
Additionally commodity prices, particularly iron ore, have been rallying since mid-June, with iron ore rising from $US53/mt to $US 76/mt, on the back of stronger Chinese economic growth numbers and higher steel margins. This appears to be encouraging Chinese steel producers to boost output, leading to stronger demand. We believe, this has also led to greater optimism in the resources sector; further illustrated by the Diggers and Dealers Mining Forum in Kalgoorlie expecting its largest turnout of delegates since 2013 and a pick-up in mining jobs. Mining jobs advertised on Seek in WA are rising, with 70% more vacancies in Australian mining industry in May alone compared to 2016.
Of the back of higher exports and the recovery in commodity prices Australia’s Current Account Deficit (CAD) has declined to the lowest level since the early 1970’s. The CAD is currently at just 0.7% of GDP, compared to historical levels of between 4%-6% of GDP. This has reduced Australia’s offshore funding needs and has meant that despite lower interest rate differential with the US the AUD has been maintained at a higher level.
The final factors is that the AUD has partly been caught up in some hawkish central banks moves, particularly the Bank of Canada lifting rates. International investors often bucket Canada and Australia together as relatively small and open resources dependant economies and so have bid up the AUD in expectation of tighter monetary policy to come. This has led to stronger offshore demand as foreign investors views around commodity prices and the potential for RBA easing have reversed.
Despite shrinking interest rate differentials the AUD has strengthened against the USD
Source: Bloomberg and CFSGAM, data as at 31 July 2017.
What will the impact be from the stronger AUD?
The stronger AUD is unlikely to alter the RBA’s policy at this stage. Based on their recent communications, while they would prefer to see the AUD closer to $US0.75, the RBA seems content to just watch and wait. Given the RBA’s recent focus on financial stability, the central banks is unlikely to cut rates just to get the AUD down. Comments in the recent Statement on Monetary Policy and Board meeting minutes have at this stage focussed on the facts around a stronger AUD and the potential risk that it could reduce their growth and inflation forecasts – rather than talking about how the RBA may push the AUD lower.
A rising AUD is typically bad news for mining companies profitability, given they sell in USD and compete against offshore producers. However, mining companies also generally hedge FX movements and the fact that most commodity prices are denominated in USD means that the weakening of the Greenback has been supportive for industrial commodity prices. This in-turn means that commodity prices have actually risen in AUD term, which we feel, is broadly positive for mining and energy equities.
Business confidence/conditions measured by the NAB survey are currently at record highs. It’s possible that the higher AUD could start to impact business confidence, particularly the export subcomponents, such as the tourism and education sectors which have been some of the greatest beneficiaries of a weaker currency. However we will likely have to wait and see for any impact to be shown here.
Overall the impact on equity markets is likely to be mixed; a stronger AUD is a problem for those companies with significant offshore earnings or exports, however it is positive for those that rely on imported goods. In general it seems that an AUD within the $US0.70’s is something of a sweet spot for both exporters and importers - so any further gain above and beyond $US0.80 are likely to have a more significant impact. Whether or not the AUD makes a move past the $US0.80 mark will likely depend on what happens with commodity prices, the outlook for the RBA and most importantly the USD.