How high could the Australian dollar go?

 abc.net.au  7/17/2017 11:19:34 PM   business reporter David Taylor

Posted July 18, 2017 09:19:34

Many see the dollar as a proxy for the strength of the Australian economy.

For example, when it hit parity with the US dollar in November 2010, financial dealing rooms around the country threw "parity parties".

There are practical benefits of a higher currency too.

If a lot of your business costs are generated offshore, then a higher dollar would normally reduce those costs.

A strong currency can also make imported consumer goods cheaper — great if you've been eyeing a big screen TV from the overseas.

Alternatively, if a country's economy is lagging because of a weak exports sector, a lower dollar may be needed.

It makes that country's goods more internationally competitive and can help to lift economic growth.

So, why is the Australian dollar rising, and can it push even higher from its current levels?

You can get a bigger bang for your buck Down Under

A key reason why the Australian dollar is rising against the greenback is due to what is called the yield on offer.

For example, if an international bond investor looks at a 10-year Australian government bond, they would see it currently returns roughly 2.7 per cent.

The same investor could then look at a US government bond and see it is worth 2.3 per cent.

Even if you're no mathematician, you can see the Australian government bond is more attractive.

The thing is, in order to buy an Australian government bond, you need to buy Australian dollars.

So, the more investors seek Australian government bonds, the higher the Australian dollar goes.

It works the same way for bank interest rates. The dollar will often rise after the Reserve Bank increases interest rates, because investors looking for a higher yield then turn to Australia.

We've golden soil

If you look at a chart of the Australian dollar over the past decade, it tells a three-part story of the dollar's connection to Australia's raw materials.

The dollar crashed during the height of the financial crisis.

It then recovered strongly to be above parity with the US dollar (helped by enormous Chinese stimulus and the increase in demand for Australia's key commodities).

But, from 2013 to 2015, it underperformed as China's economic growth slowed.

Much of the dollar's value is tied up in the demand for Australian iron ore, gas and coal.

Indeed, the dollar's ascension from the recent low of 68 US cents in January 2016 to the high-70s in April 2016 coincided with a significant lift in the price of iron ore from $US40 a tonne to about $US90 a tonne.

However, recently, analysts have been scratching their heads, because the traditional link between the price of iron ore and the value of the dollar has broken.

The price of iron ore has dropped back down to about $US65 a tonne, while the dollar has kept climbing.

While the outlook for commodities prices remains supportive of a stronger dollar and the Metal Bulletin Iron Ore Index has been rising since mid-June, there must be something else driving the local currency right now.

So, what is it?

Throwing caution to the wind

Economists and traders have a term called "risk appetite".

It refers to broad enthusiasm for what are traditionally seen as riskier assets like shares.

Right now, Wall Street has been pushing record highs, and Australia's benchmark S&P/ASX 200 edged towards its own five-year high back in April.

That tells you investors are keen to take some risks.

There is also a direct correlation between an increase in risk appetite and demand for the Australian dollar.

Why the sudden surge?

So, that's broadly what is supporting the Australian dollar. What about right now though?

Westpac head of global strategy Robert Rennie told ABC News that fair value for the dollar is currently between 72 US cents and 78 US cents — so it's essentially looking "expensive" now from a currency value perspective.

Over the past week, two events took place that pushed the dollar above 78 US cents.

The first was a speech by US Federal Reserve chair Janet Yellen, which poured cold water over the idea the US would need to brace for a series of sharp interest rate increases.

Dr Yellen insisted the pace of rate rises would be "gradual" and dependent on rising inflation (which is far from guaranteed).

Interest rate increases act as a magnet for currency traders.

The higher the interest rate, the more interest in the country's currency (because of the higher yield mentioned earlier).

So, when Dr Yellen uttered those words, currency traders jumped out of the US dollar and looked elsewhere.

That weakness in the US dollar caused the Australian dollar to appreciate against it.

The second is better than expected economic data from China.

The Chinese economy grew at 6.9 per cent per annum in the June quarter, above forecasts of 6.8 per cent.

That's a very fast-moving economy!

It also highlights the potential demand for Australian exports and, hence, future demand for the Australian dollar.

Perfect report card

Australia's AAA credit rating has also played a significant role supporting the value of the dollar.

From a financial health point of view, Australia's pretty fit by international standards.

Canada, Denmark, Germany, Hong Kong, Netherlands, Norway, Singapore, Sweden and Switzerland all have AAA credit ratings.

That may sound like a lot of countries, but Australia also has a record run rate when it comes to recession-free economic growth.

ABC News has been told that some very large billion-dollar-plus global hedge funds are favouring the Australian dollar and government bonds because of that factor.

It is a key reason why currency traders that ABC News spoke to were confident the Australian dollar would not "crash" from these levels.

Indeed, Urbis chief economist Nicki Hutley said it was entirely possible the Australian dollar would push above 80 US cents in the coming months.

Topics: currency, money-and-monetary-policy, australia

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