Down, down, dollar down

The Australian dollar (AUD) has just experienced its biggest five-day fall this year. A surprisingly soft CPI report on Wednesday has driven the Australian dollar down from close to US$0.79 a week ago to just above US$0.76 currently. While this may not seem like much given the sharp fluctuations seen in the currency over recent years, it has taken the AUD down to its lowest level since July.

In our view, the AUD is likely to remain under pressure in the coming year. While forecasting week-to-week currency movements is notoriously difficult, over the medium-term horizon economic fundamentals play a much greater role in determining currency movements. And these fundamentals suggest the AUD has further to fall.

One classic approach for forecasting currencies is the theory of purchasing power parity (PPP). Think here of The Economist’s Big Mac Index. That is, a Big Mac costs A$5.90 in Australia and US$5.30 in the US. If this was the only commodity, and we could ship Big Mac’s instantaneously between the two countries without cost or fear of food poisoning, then the AUD-USD exchange rate should be US$0.90. Of course, this is an over-simplified example and we consume far more than just Big Macs. A more sophisticated technique adopted by the OECD that looks at a basket of around 3000 goods and services produces a PPP exchange rate of US$0.68.

This is known as an absolute PPP estimate. Over the years, academics have found little support for absolute PPPs in explaining exchange rate movements. But a closely related concept, known as relative PPP, has had much more success in explaining exchange rate movements over the long-run. Relative PPP relates changes in the exchange rate to inflation differentials between two countries – that is, if prices in the US rise by 1% more than in Australia, then the AUD exchange rate should appreciate by 1% in the long-run. Based on historic inflation rates in Australia and the US, we estimate the current relative PPP value of the AUD to be around US$0.72.

While relative PPP is a good anchor for exchange rates over the medium-term, shorter-term movements in the currency are often dominated by other factors. In the case of Australia, these include changes in our terms of trade (export prices relative to import prices) and interest rate differentials.       

After the global financial crisis, these two factors conspired to drive the AUD up to over US$1.10 in 2011. Our terms of trade jumped 40% between 2009 and 2011 supported by Chinese demand for our commodities, while our cash rates were 4.625ppts above the US, promoting substantial capital inflows.

However, as Chinese growth cooled and commodity prices corrected (also partly due to increased supply), our terms of trade reversed these gains over the next five years. At the same time, the RBA cut rates to 1.50% (and market expectations were for more), lowering the interest rate differential with the US. These forces led the AUD to drop under US$0.69 in early 2016.

Since then a recovery in Chinese growth and commodity prices (with our terms of trade up around 20% from their lows), combined with expectations of fewer US Federal Reserve rate hikes pushed the AUD up to almost US$0.81 in September. We were, and continue to be, of the view that an AUD in the US$0.80s is unsustainable.

Under our forecasts, commodity prices should fall a little over the coming year, reflecting a slight moderation in Chinese growth and additional commodity supply. This should push the terms of trade down around 10% from current levels. Furthermore, we continue to expect more rate hikes by the US Federal Reserve than the market. By Q2 2018, we expect two rate hikes by the Fed and none by the RBA. This will push US rates above those in Australia for the first time since 2000, when the AUD was close to US$0.50. While the AUD will not drop to these levels, given much higher terms of trade today than in 2000, the reduced rate differential should be sufficient to drive the currency back towards our long-run relative PPP value of US$0.72 by the end of 2018. 

Table 1: Financial market movements, 19 - 26, October 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,560.4

-0.1%

US

2.46%

14.3 bps

US Dollar Index (DXY)

94.61

1.4%

Nikkei 225

21,739.8

1.4%

Japan

0.07%

0.3 bps

USD-JPY

113.98

1.3%

FTSE 100

7,486.5

-0.5%

UK

1.38%

10.5 bps

GBP-USD

1.316

0.0%

DAX

13,133.3

1.1%

Germany

0.42%

2.0 bps

EUR-USD

1.165

-1.7%

S&P/ASX 200

5,916.3

0.3%

Australia

2.76%

-0.7 bps

AUD-USD

0.766

-2.8%

Source: Bloomberg

 

Read the full report here.

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