Tracking The Fortunes of The Aussie Dollar Over The Next 18 Months

Businessman holding money  - Australian dollars
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The Reserve Bank has made a hash of suppressing the Aussie dollar of late. Two rate cuts since February have failed to push down the value of the local currency as intended.

Only two months ago, the RBA’s target for the dollar sat at $0.70. That figure was revised up to $0.75 once their looser monetary policy was shown to be ineffective. But, privately, that must have been an admission of defeat.

However, according to a survey of 25 leading academics and economists, the Aussie dollar is actually trading at close to its fair value.

Economists calculate the fair value using a number of different metrics. For the most part, they refer to Australia’s trade balance, while also looking at the difference between Australian and US government bond yields.

Using these measurements, economists calculated the fair value of the dollar at $0.738. That’s only $0.02 lower than its current $0.76 level.

On the other hand, long term projections for the dollar threw up mixed responses.

Some economists predict the AUD will climb to $0.80 over the next 18 months. Others see it trending in the opposite direction, falling down to as low as $0.68.

The RBA would prefer to see the dollar hit that level, as it would help make Aussie goods cheaper to export.

Still, this broad range of forecasts is predictable given the uncertainty over the RBA’s future rate policy. The real question is: when will the RBA decide to lift rates?

We can make a few educated guesses as to their future intentions.

I tend to agree with economists who see the RBA shaving another 0.50% off the cash rate in the next 12 months. Partly, any such decision will be about lowering borrowing costs for consumers and businesses. The RBA is keen to increase spending in the economy, which is projected to fall by $100 billion over the next year.

The other reason for this relates to the RBA’s US central bank counterpart, the Federal Reserve. Should US interest rates stay at near zero until mid 2016, the RBA is likely to lower rates. That’s because the RBA is hoping to see rising US rates weighing down on the Aussie dollar.

That would take some pressure off the RBA in having to make a decision over whether to raise rates. And with the unemployment rate at 6.1%, the RBA will be hesitant about hiking interest rates.

On the other hand, it’s hard to see the US Fed lifting rates until late 2016. Hard as they may try to convince the markets that things are improving, economic data suggests otherwise.

What the US jobs data tells us about interest rates

The US unemployment rate fell to 5.3% in June, its lowest point in seven years. A total of 3 million jobs were created in the past 12 months. Officials expect to see another 3 million jobs created, with the long term outlook penning the unemployment rate between 5–5.2%.

On the surface, these are respectable figures. But the markets weren’t buying it. Too many questions remain over the usefulness of this data.

For one, why is it that US wages remain persistently weak? Annual wage growth actually fell from 2.3% to 2%. If the jobs market was improving, we’d see it reflected in higher wages.

At the same time, can we take these figures seriously when so many people have stopped looking for work? The American labour force dropped by 432,000 in June. That may make the unemployment rate look good on paper, but it’s less positive news for the broader US economy. It shows that people are less confident about finding decent paying jobs — or any kind of job for that matter.

This exodus has resulted in the lowest labour participation rate since 1977.

Some analysts are putting the declining participation rates to a rise in retirements. There is some truth to this, because the number of baby boomers retiring every year remains high. But that’s been the case for years.

Despite that, we’re still seeing US data show falling participation year on year. If these economists are right, then participation will rise in the coming months.

After all, if the US economy is actually improving, then it’s logical to conclude that market confidence will match that.

But if the participation rate is a sign of a more permanent decline, it would mean the US economy is already close to full employment with near zero interest rates. That’s only going to increase pressure on the Fed to raise rates, as inflationary pressures start to build.

So if the unemployment rates continues to fall, then wages will have to rise in line with this. If you have a lot of people looking for a limited amount of jobs, then wages inevitably go up. Again, this assumes that those who have stopped looking for work plan on returning.

Nonetheless, if the markets get the impression things are improving, then a rate rise may come between September and December. We’ll know more once it becomes clearer where wages are heading. The participation numbers will be important to watch here too. They’ll prove whether the participation problem is cyclical or structural.

If it’s structural, then the US economy will only worsen in the long run. The Fed would have little recourse to raise rates in that scenario. However, a cyclical trend will suggest that economic conditions are improving. That’s something the RBA will be hoping to see, as it would hasten a US rate rise.

Where will the Aussie dollar be by 2017?

One of the problems with the strategy of waiting for the Fed to make their move is that, eventually, the RBA will have to aswell. While a rate hike is unlikely over the next 12 months, it will happen eventually. The only question is how low will rates go before the RBA reverses their policy?

Economists who say the RBA will keep rates at 2% predict rates will rise to 3–3.5% by June next year. If the US holds off on raising rates until then, it could offset any benefits the AUD gets from this.

So where does that leave us?

It’s possible the Aussie dollar will fall to around $0.70 by June next year. Commodity prices are also likely to continue to drop, especially with iron ore output set to increase. Weaker demand from China will also play a big role in suppressing prices.

Aside from that, the RBA could well lower rates again by 0.50% over the next year. This would be a stop gap measure until the US begins to raise rates. The effects of it on the Aussie economy would be limited, but it should keep the dollar closer to $0.70.

By June 2016, the great monetary policy reversal is likely to begin in earnest. After that, all bets are off. It’s difficult to predict where rates will end up once the Fed make their first move. Yet this makes it more likely that the Aussie dollar’s floor could be $0.70 for the next 18 months.

Mat Spasic,

Contributor, The Daily Reckoning

PS: The US is not the only nation struggling to find a balance between exports and economic prosperity. The RBA hopes that a strong US dollar — and a weaker Aussie dollar — will be the tonic to lift Australia’s struggling economy. But with the trade deficit rising in Australia, it may not be enough to prevent a longterm decline.

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