As good as it gets for the Aussie dollar

Having doubled in value against the $US during the past decade, it’s likely the Australian dollar’s best days are behind it.

The $A rose from a low in 2001 of $US0.48 to a 2011 high of $US1.10; since 2011, however, the outlook for the $A has become less clear.

Purchasing power parity

One of most common ways to value a currency is to compare relative prices. According to purchasing power parity theory, exchange rates should equilibrate the price of a basket of goods and services across countries, such that $A100 would buy the same basket of goods in other countries as it does in Australia.

However purchasing power parity doesn’t work for extended periods, with huge divergences evident at various points in time.

The $A as has gone from being dramatically undervalued in 2001 to similarly overvalued now and the currency could face downward pressure if some of the factors that have been holding it up are reversed. The major factors on this front are commodity prices, relative monetary policies, and perceptions of Australia as a safe haven.

Commodity price boom starts to fray

With commodities making up about 70 per cent of Australia’s exports, swings in commodity prices have been the main driver of the big-picture shifts in the $A during the past 40 years.

Growth in China remains strong but it has slowed a bit (from 10 per cent-plus growth to between 7 per cent and 8 per cent) just at the time when the supply of commodities is about to surge after record levels of mining investment globally.

Relative monetary policies

Quantitative easing in the US, Japan and elsewhere should be positive for the $A as it means an increase in the supply of US dollars, yen etc, relative to the supply of Australian dollars. And indeed it has been.

Various rounds of quantitative easing in the US have been associated with $A strengthening, and the heightened efforts by Japan on this front only add to this pressure and have helped to push the $A up. Our assessment remains that as the value of the yen continues to fall in response to aggressive monetary stimulus from the Bank of Japan, the $A will make further gains against the yen, taking it to around ¥110 by year’s end.

However, against the $US the impact of quantitative easing may be starting to wane a bit. The main reason is that the interest rate differential in favour of Australia has fallen dramatically as the RBA has cut rates. With the Australian economy still struggling this may have further to go.

Central bank buying and safe-haven demand

Buying by central banks looking to diversify their foreign exchange reserves and by investors allocating to a diminishing pool of safe AAA-rated countries has no doubt played a role in boosting the $A, but after a decade-long bull market in the $A (or bear market in the $US) the central banks are late to the $A party.

And with the mining boom fading and the government struggling to bring the budget back into surplus, it has to be recognised that Australia is not without risk. So my feeling is that this source of support for the $A will start to fade.

Shane Oliver is head of investment strategy and chief economist at AMP Capital