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Mind the Gap: What Lies in Store for the Australian Dollar?

We’ve been discussing ‘money’ this week, as in the intangible concept of what money is and where it comes from. Our aim was to show you that intangible qualities like credit, credibility, hope and confidence, create modern money…not central bankers manning a printing press. Their job is simply to ensure money doesn’t disappear from the system, which in turn creates hope and confidence in that system.

Today, we’ll refrain from delving deeper into the question of what modern money is. For that you’re probably thankful. Instead, we’ll look something a little more tangible — currency. It’s a related subject anyway — currency simply being a name for money’s ‘unit of account’ function — so you’re not escaping the topic entirely.

So, what’s going on with the Australian Dollar? It used to be a ‘risk-on’ currency. That is, when the world was bullish and happy to embrace risk, Aussie dollars were first on the shopping list. Now, the world is still bullish, but it looks like the world may have had their fill of the Aussie. Except for the Japanese, of course. In fact, the strength of the Australian dollar versus the yen has obscured the fact that our currency hasn’t performed too well lately against the other major currencies.

Is this is an important sign to keep an eye on? Let’s have a look…

The chart below plots the AUD/USD exchange rate (in red) versus the S&P500 (black line). There is a decent correlation between the two. And in the context of the ‘risk-on’ trade, that makes sense. When speculators are bullish, they buy stocks (S&P500) and peripheral currencies like the Aussie dollar. The rationale is that it’s an anti-dollar/anti-cash trade; buy stocks, buy foreign currencies, buy anything, just don’t sit in USD cash.

Another Divergence — the Australian Dollar and S&P500 Part Ways
 

Source: StockCharts

 

But since early January the Australian dollar and the S&P500 decided to part ways. We’re not exactly sure what this means. It may have something to do with the monetary craziness going on over in Japan, which is screwing with currencies and cross-rates everywhere.

But we think it has more to do with the poor performance of the Australian economy lately. The RBA’s interest rate cuts are not having the same effect this time around. They’re pumping up the stock market as it forces speculators to ‘search for yield’ (an ultimately unhappy search) but back in the real economy, the response to cheaper money has been disappointing.

We’ve seen it in weak housing loan data, tepid retail sales, and the RBA itself downgrading GDP forecasts for Australia last week.

And China’s ‘echo’ credit boom, giving one last hurrah to iron ore and coal producers, is not providing the fuel for the Australian dollar that you would expect. So while the world remains bullish on equities and just about all forms of debt, it’s shunned the Aussie dollar.

It’s not just against the US dollar either. The world’s most despised currency, the euro, has shown great strength lately. Since peaking at around 86 euro cents in August 2012, the Australian dollar now buys around 76.6 euro cents. That’s a decline of nearly 11% in 6 months.

We recommended the Euro ETF (ASX: EEU) to subscribers of Sound Money. Sound Investments back in August last year as a hedge against expected Aussie dollar weakness. It seemed crazy at the time. But, combined, Eurozone countries have the largest stash of gold in the world (over 10,000 tonnes), the ECB marks its gold to market every quarter, giving its balance sheet a semblance of solidity in a world of paper, and lastly, the Eurozone runs a balanced trade account…unlike Australia, the US and Britain, for example.

So fundamentally, the currency is solid. There’s just the little matter of whether Eurozone countries can get along. There’s tremendous political will to make that happen. Whether ‘political will’ can hold democracy at bay is another question…but Europe has a great history of imposing political will on people for an extended time. So there’s life in the euro yet.

Aussie Dollar — Falling Against the Euro Too
 

Source: Yahoo Finance

 

The movement of the Australian dollar probably tells you a couple of things. Firstly, its weakness against the euro indicates an unwinding of the ‘safe-haven trade’, where uncertainty over the euro’s future saw capital flight from the region to just about anywhere.

As we mentioned, it tells you the world is no longer enamoured with the Australian economy. The slowdown in China that got underway in 2012 was a sign of things to come. The great mining boom that by 2011 had narrowed to the great bulk commodity boom (which resulted in an insane tax) is now in its final stages.

And despite the RBA’s efforts, it certainly doesn’t look like a renewed housing boom will take the place of the waning mining boom. That’s what a weaker currency is telling you.

While it’s a sign of a weaker future economy, it could benefit some sectors hurt by persistent currency strength. There are swings and roundabouts in currency fluctuations, so it’s not all bad.

But looking again at the chart of the Australian dollar and the S&P500, it will be interesting to see whether more divergence or convergence lies ahead. For more divergence, buy the S&P500 for a double return hit. For convergence, sell.

So place your bets. And then hedge them. Your friendly investment bank will have all the products you need. Such is life in the 21st century casino, where the house ALWAYS wins.

Greg Canavan
for The Daily Reckoning Australia

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From the Archives…

Money in the Time of Financial Cholera
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Dishonest Leaders and Delusional Voters
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Uranium: The Commodity Like Gold Ten Years Ago
6-02-13 – Byron King

How Australia-China Relations Are Caught in the Monetary Battle Space
5-02-13 – Dan Denning

The Great Rotation Into Stocks
4-02-13 – Dan Denning

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