Back in November we saw five reasons to expect a higher $A. These largely remain valid and the $A seems to be perking up again.
And vice versa if Australian inflation falls relative to the US. Consistent with this, the $A tends to move in line with relative price differentials or its PPP implied level over the long-term. This concept has been popularised over many years by the Big Mac Index in The Economist magazine. Over the last 25 years the $A has swung from being very cheap (with Australia being seen as an old economy in the tech boom) to being very expensive into the early 2010s with the commodity boom. Right now, it’s modestly cheap again at just above $US0.67 compared to fair value around $US0.72 on a PPP basis.
Source: RBA, ABS, AMP
Money market expectations show a narrowing of the negative gap between the RBAs cash rate and the Fed Funds rate as the Fed is expected to cut by more than the RBA. As can be seen in the next chart, periods when the gap between the RBA cash rate and the Fed Funds rate falls have seen a fall in the value of the $A (see arrows – and this being the case more recently) whereas periods where the gap is widening have tended to be associated with a rising $A. More broadly the $US is expected to fall further against major currencies as US interest rates top out.
The dashed part of the rate gap line reflects money mkt expectations. Source: Bloomberg, AMP
Source: Bloomberg, AMP
Source: Bloomberg, AMP
A current account around balance means roughly balanced natural transactional demand for and supply of the $A. This is a far stronger position than pre-COVID when there was an excess of supply over demand for the $A which periodically pushed the $A down.
Source: ABS, AMP
We expect the combination of the Fed cutting earlier and more aggressively than the RBA, a falling $US at a time when the $A is undervalued and positioning towards it is still short, to push the $A up to around or slightly above $US0.70 into next year.
There are two main downside risks for the $A. The first is if the global and/or Australian economies slide into recession – this is not our base case but it’s a very high risk. The second big risk would be if Trump is elected and sets off a new global trade war with his campaign plans for 10% tariffs on all imports and a 60% tariff on imports from China. If either or both of these occur, it could result in a new leg down in the $A, as it is a growth sensitive currency, and a rebound in the relatively defensive $US.
For Australian-based investors, a rise in the $A will reduce the value of international assets (and hence their return), and vice versa for a fall in the $A. The decline in the $A over the last three years has enhanced the returns from global shares in Australian dollar terms. When investing in international assets, an Australian investor has the choice of being hedged (which removes this currency impact) or unhedged (which leaves the investor exposed to $A changes). Given our expectation for the $A to rise further into next year there is a case for investors to stay tilted towards a more hedged exposure of their international investments.
However, this should not be taken to an extreme. First, currency forecasting is hard to get right. And with recession and geopolitical risk remaining high, the rebound in the $A could turn out to be short lived. Second, having foreign currency in an investor’s portfolio via unhedged foreign investments is a good diversifier if the economic and commodity outlook turns sour, as over the last few decades major falls in global shares have tended to see sharp falls in the $A which offsets the fall in global share values for Australian investors. So having an exposure to foreign exchange provides good protection against threats to the global outlook.
Source: AMP
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