Australian Dollar Valuation report

October 14, 2011

FOREX

I put together an Australian Dollar long term valuation report for MacroBusiness which was picked up in the SMH and Age yesterday as an excerpt. Here is the excerpt that went in the media. If you would like the full report please feel free to email me a full version or sign up at Macrobusiness using the full link. In that way you’ll get my currency stuff but also my colleagues good work on equities, housing and many other topics.

I will continue to publish all of my stuff here but I am but one person with a small and dedicated team, MacroBusiness is a much larger team and broader church and is fast becoming the obvious alternative  in the Australian market place to the usual flow of spruiking and thin slicing you see everyday. We try to be fair but our no-nonsense approach means we often take an opposing view to conventional wisdom – healthy skepticism without being bombastic I reckon although the special interest groups might disagree sometimes.

Anyway here is the excerpt of the longer Australian Dollar valuation piece from the SMH and Age

The rise and rise of the Aussie dollar

Greg McKenna

October 13, 2011 – 12:41PMComments 11

But, as we all know, power doesn’t just reside in individuals. There are external factors or influences beyond even the most powerful person’s grasp.

The Arab Spring and the nascent “Occupy Wall Street” protests are a couple of examples. As is the internet’s ability to subvert institutionalised power structure.

So the AFR compiled a Power List for the inanimate as well. The internet came in first. Number 3 was climate change, number 4 was China and number 5 was the cost of living.

What came in at number 2?

The most important transfer price in our economy, something near and dear to my heart – the Australian dollar!

And there’s no doubt about. The dollar has the power to, and is, reshaping our economy away from industries such as tourism, education and manufacturing and towards mining.

But it wasn’t always this way. Indeed, even until relatively recently, the dollar was caught in a long term decline:

 
77113 gg1 The rise and rise of the Aussie dollar

The chart above is the monthly close of the Australian dollar since US President Richard Nixon closed the Gold Window in 1971.

For most of this post-Bretton Woods period, corporations, traders and investors have been trained to question the credibility and durability of any and all Australian dollar rallies.

Misunderstandings

A couple of things about this former trend are commonly misunderstood by currency market participants.

The first is that the seventies and before were a very different world in which the tail-end of post-war reconstruction and globalising consumerism valued material ‘stuff’ very highly. Thus Australian commodities were in demand and the dollar sat at a very high level, even if controlled.

Well before the float in the eighties, this paradigm had begun to shift towards the accelerated credit-creation of private sector banks as services became the centre-piece of global growth.

Post float and into the nineties, this services and credit model culminated in the celebration of the internet, the very antithesis of “stuff”.

In this environment, the Australian dollar was a structural turkey, fluctuating but ultimately driven down to an all-time low in April 2001 around the 0.4775 US cent level, “the half-buck buck” as it were.

You can also see in the chart above the linear downtrend since 1971 and the 200-week moving average, both of which are well below the current price.

So i’ts easy to see why many people are still trading, waiting and hoping for the Australian dollar to fall.

Trend shift

But times have changed. As the chart shows, the great downtrend is broken. The Reserve Bank of Australia thinks that this as a structural shift and has said that:

Historically, it has been possible to explain broad movements in the Australian dollar exchange rate by considering two important economic fundamentals, namely the terms of trade (which typically move in line with global commodity prices) and the differential between domestic and foreign interest rates. Strong world growth tends to put upward pressure on commodity prices and the terms of trade; this strengthens the outlook for returns on Australian dollar assets and increases the demand for Australian dollars from exporters, which is usually reflected in an appreciation of the exchange rate. Similarly, all else equal, strength in the domestic economy relative to the rest of the world tends to be associated with a larger interest rate differential, which also acts to appreciate the exchange rate.

Trading places

Looking at the Terms of Trade since 1959 we can see the context of the current rise and why it might be impacting on the Australian dollar so materially:

87ec2 gg2 The rise and rise of the Aussie dollar

The red line is the average since 1959 of 67.58 US cents, the average since 1971 when Nixon closed the gold window is roughly similar at 67.3. The yellow line is the average of Australia’s terms of trade since China joined the WTO in 2001. The terms of trade clearly illustrate a material impact.

Global growth and the terms of trade are obviously important but as the RBA points out above interest rate differentials are also important.

That is certainly the case in a world of money manager capitalism where the interest rate differentials are an excuse to take currency exposure.

Not only does the pick-up between Australia and other nations give an incentive to buy Australian dollars, it gives an excuse to take currency risk in your portfolio for a sizable pick-up if you get the trade right. But does the linkage stack up?

a7c26 gg3 The rise and rise of the Aussie dollar

It’s not a perfect correlation, naturally, as there are many drivers of the Australian dollar, but you get a sense of how important the differential is (in this case I have used the Australian 2-year yield minus the US-2 year yield) from this chart.

The box represents the period between the mid-late 1990’s and the very early 2000’s when the differential was below 1 per cent, indeed negative for a period, when the differential gave no support to the Australian dollar.

Add in a bit of terms of trade weakness, the lack of interest in “stuff” and you have the legs kicked out from the Australian dollar based on the RBA’s simple model above.

But as I have argued before, there is more to valuing the Australian dollar than the terms of trade and interest rate differentials.

Indeed, my fair valuation model has five key drivers. The RBA has covered the above two; the other three are:

  • The USD – the other side of the coin
  • Global risk appetite/aversion
  • Technicals

Outlook

If we bear the five factors in mind, it is possible to establish long-term valuation trends. In the medium term it looks to me like we might have get used to a much higher exchange rate on average – volatile as always but higher.

The long-run average since the float in 1983 if I use quarterly rests is 0.7425 US cents. If we go back to 1971, which might be a more relevant comparison, we see the average increases to 0.8783 with a high of 1.4850 at the end of the 2nd and 3rd quarters 1974.

Is our past our future? It just might be.

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