Why Only China Can Save the Aussie Dollar

Why Only China Can Save the Aussie Dollar

One of the biggest changes to the Australian market is set to take place. And chances are you probably don’t know much about it.

On Wednesday the US Federal Reserve Bank begins its two-day monetary policy meeting.

Financial markets are betting there’s a 113% chance the Fed will increase the funds rate — the cash rate — by 25 basis points.

A ‘113% chance’ the Fed will jack up interest rates means the increase is about as sure as a sure thing gets. The US market is expecting it, as is the global market.

Of course, this rate increase from the Fed was confirmed by the bond market a month ago.

In February this year, the price of a 10-year US Treasury bond rose 0.18% above a 10-year Aussie bond. In other words, the 10-year US Treasury bond was offering a yield of 2.90% compared to the 10-year Aussie bond of 2.72%.

That is, you would earn more interest putting your money into US bonds than Aussie-dollar bonds.

This price spike in bonds was yet another signal confirming this week’s imminent rate hike from the Fed. The announcement is expected on Friday morning Australia-time.

Given the market sees the rate increase as a given, there should be very little reaction from the US market. So, when the Aussie market opens a few hours later, it should be a relatively calm session.

However, this move from the Fed now puts Australia in an awkward position.

It’s something that occurs infrequently in our market. For many investors and analysts, it may only happen once or twice in their lifetimes.

Come Friday morning, Australia will officially lose its interest rate advantage over the US.

With the Fed expected to bump up the rate by 0.25%, the US will be offering a higher interest rate than Australia. For the first time since 2001, the Reserve Bank of Australia (RBA) will have a cash rate of 1.5% compared to the Fed’s 1.75%.

The interest rate advantage simply means that if another central bank is offering a higher base rate than the RBA, they are more likely to attract overseas capital. In other words, money kept in a country with a higher interest rate is the better investment decision.

Last time this occurred was 20 years ago.

In December 1998, both the Fed and RBA dropped the cash rate to 4.75%. The Fed went first in November that year, with the RBA following a few weeks later.

Over the following two years, the RBA’s monetary policy decisions trailed the Fed by a couple of months. If the Fed raised or lowered rates, the RBA followed suit within a couple of months.

You can see this play out in the chart below.

US Fed funds rate versus RBA cash rate 1995–2018

Source: Trading Economics

Inside that red circle, you can see how the RBA’s policy decisions (black line) lagged those of the Fed (blue line) fairly consistently.

In March 2001, when the dotcom bubble burst, it caused then Fed chair Alan Greenspan to drop the Fed funds rate to 1.75%. The RBA, on the other hand, broke away from trailing the Fed and didn’t go lower than 4.25%, beginning to raise rates again by the middle of 2002.

This three-year period in which the RBA cash rate was lower than the Fed funds rate was brutal for the Aussie dollar. The Aussie dropped from 70 US cents in 1997 (during the Asian financial crisis) to a low of 49 US cents just before the RBA stopped shadowing the Fed’s policy moves.

However, this time, it’s slightly different.

Australia has always been considered a riskier currency than others. That’s because we are treated as a commodity-based currency, much like the Canadian dollar. Our dollars are closely correlated to the value of commodities.

This is why our dollars have hovered either side of 80 US cents on the back of the Fed’s two-and-a-half-year rate increases…while the RBA has cut rates at the same time.

We may be losing our interest rate advantage to the US for now. And in the past it has weakened the Aussie dollar. However, in the short term at least, the Aussie may continue to remain above 75 cents.

Aussie dollar tracks commodity exports

Source: Bloomberg

You can see above that, since 2009, the Aussie dollar (blue line) has been moving in lockstep with the RBA’s index of Australian commodities (white line), rather than the Aussie US 10-year yield bond spread (purple line).

While all three were closely correlated at the turn of the century, this broke with the start of the financial crisis. Since then, our dollar’s value has closely moved with the value of commodities.

More importantly, though, our currency is moving in line with Chinese demand for Aussie dollars.

Simply put, the key driver of the Aussie dollar these days is Chinese demand. The world’s second largest economy underpins what our dollar is worth.

If China goes on an iron ore buying spree, our currency will remain high. Should China curb its insatiable appetite for our rocks, the Aussie dollar will fall.

For the past decade, our currency’s value has been determined less and less by what the Fed does. Nowadays, it’s only China that can save the Aussie dollar.

Kind regards,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia