Aussie dollar enters slippery dip

Aussie dollar enters slippery dip

Nine years ago this month, I was in the US.

The US was in the grip of a recession…

People were lucky to have jobs…

The homelessness problem was worse in major cities after the subprime crisis left thousands without a house…

It was tough.

Unless, of course, you were an Aussie.

Because for once, walking into the US with a bunch of Aussie dollars made you feel rich…

From parity to half

Nine years ago this month, the Aussie dollar was trading at 90 US cents.  

And a year after that, the Aussie dollar was actually worth more than the US dollar. One Aussie dollar was equal to US$1.05.

It was a confusing time for analysts. We’ve spent out entire careers looking at the currency pair in a certain way. So to see the Aussie dollar as the higher valued figure was, well, odd.

Of course, it didn’t last. By 2012, the days of parity with the US dollar were over…and the Aussie dollar began its long slide down to today’s 68 US cents.

And today, I’m here to tell you that things are about to get a whole lot worse for the Aussie dollar.

In fact, I think there’s a chance the Aussie dollar is going to sink all the way down to 50 US cents…

Sounds mad, right?

The Aussie dollar dipping all the way down to financial crisis lows.

Well, not only is it possible but also probable.

Let me show you why.

Red dirt drives the Aussie dollar

Currency movements are complex.

But when it comes to the Aussie dollar, we can simplify it somewhat.

You see, the Aussie dollar is a commodity-based currency.

Because Australia is a major exporter of commodities, changes in the value of commodities affect the value of the Aussie dollar.

The most notable one is iron ore. We predominantly export iron ore to the world, and for that reason the Aussie dollar tends to track the movements in iron ore quite closely.

Have a look:

Iron ore price in US dollars (left axis) versus Aussie dollar (right axis)

Source: Trading Economics

While it’s not a lockstep movement, this chart shows us that the Aussie dollar (black dotted line) tends to follow the overall trend of the iron ore price (blue line).

Why is that?

Mostly because iron ore is Australia’s largest export. When iron ore prices are high, it generates a high income for the Aussie economy. In fact, iron ore prices have the biggest effect on Australia’s national income.

So when the price of iron ore rises, it stands to reason that Australia will ‘earn’ more money, and the Aussie dollar goes up as a result.

However, when iron ore falls, it means our income will fall too. So the Aussie dollar falls to reflect the reduction in national income.

To boot, a lower iron ore price means that our government will receive less income through tax. Meaning the government may need to increase debt in order to maintain the government budget.

This relationship shows us just how important iron ore is to the Aussie economy.

But our red dirt isn’t the only factor when it comes to the Aussie dollar. The other crucial component is interest rates.

Cash rate supports it

Think of it like this.

The value of iron ore prices may drive the Aussie dollar.

But the cash rate, as set by the Reserve Bank of Australia, supports the Aussie dollar.

And right now, the Aussie dollar is about to have this support whipped out from underneath it.

You see, a high Aussie cash rate means we are likely to attract foreign capital to our shores. Companies and people park their money here as it is likely to earn more interest compared to other countries.

In turn, the higher dollar value helps bring more investment into the country.

Except over the past couple of years, the US Federal Reserve has been increasing rates. And it now offers a higher interest rate than Australia’s 1.5%, making it more attractive to put money into the US than here.

Furthermore, the lower interest rate reduces the appeal of the Aussie dollar, and subsequently the demand for it. In other words, the value of the Aussie dollar falls.

And this is about to get a whole lot worse.

The markets ad most punters are widely expecting a rate cut in a couple of weeks. That will bring our cash rate down to 1.25%.

However, another rate cut is expected to follow in the next 12 months.

Meaning Aussies could be looking at a cash rate of 1% by as early as Christmas this year.

Two interest rate cuts from the RBA are actually a bad sign. And that will flow into the Aussie dollar and see it fall dramatically.

Exactly how quickly the Aussie dollar tanks is anyone’s guess.

Free fall to 50 cents?

In addition to wondering how quickly the Aussie dollar will fall, the other question to ask is: How low can it go?

To be honest, 50 US cents is a guess. But it’s not impossible. It happened before in the peak of the financial crisis. It also happened during the dotcom bust.

It could potentially drop into that range again.

Already, the Aussie dollar has dipped to 68 US cents. A tumble to 65 US cents after the first rate move isn’t out of the question.

The point is, interest rate decisions support the Aussie dollar. And the RBA is essentially removing that support by reducing the value of interest rates.

Yes, the iron price remains high.

In truth, that’s possibly the only thing keeping the Aussie dollar where it is for now.

What remains to be seen is how long the iron ore price can prevent the Aussie dollar from falling.

Because once the Aussie dollar is in freefall, there’s a whole other bunch of problems coming our way.

More on that next week.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia