$A: between a rock and a dark place

Historically, the Australian dollar has been driven by the yield premium the nation’s bonds offer over developed market peers and, to a lesser degree, commodity prices. 

" Given markets have priced in the divergence in monetary policy between Australia and the US, commodities are the swing factor." Narayanan Somasundaram, economics & finance reporter.

But recently the currency has received support from a synchronised global economic expansion, a well-performing Australian economy, a structural narrowing in Australia’s current account deficit and broad-based US dollar weakness.

Australia’s current account deficit has shrunk to $A3.1 billion in the quarter ended March 31 – the lowest in 15 years. It’s the red stuff and the black stuff now driving the dollar.

Given markets have priced in the divergence in monetary policy between Australia, where the Reserve Bank of Australia is expected to stay on hold for the rest of the year, and the US Federal Reserve - seen raising rates twice in 2017 - commodities are the swing factor, many economists and market analysts say.

“We do put weight on the narrowing interest rate premium, but I’d place more emphasis on what happens to commodity prices,” Paul Dales, chief Australia & New Zealand economist at Capital Economics says.

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Outweighed

In the past commodity prices have outweighed interest rate differentials, the last time in 2010-12 when the nation experienced a trade surplus. That is happening once again.

Australia is reaping the benefits of the once-in-a century mining investment boom which began a decade ago. As a result, trade surpluses are rising as resource exports are continuing to push record highs. Iron ore prices are at their highest point since April and the investment through the boom means volumes are surging.

Adding to that is the rising Asian income and investment story which is boosting services exports. Low interest rates globally are reducing the repayment on the nation’s foreign debt.

All of this means Australia is running trade surpluses and its current account is improving.

Australia has recorded a trade surplus since November last year thanks to higher commodity prices and booming exports. The surplus since then has totalled $A16.8 billion almost negating the $A20 billion deficit over the rest of 2016, according to data from the Australian Bureau of Statistics.

Before November, the nation last recorded a trade surplus in March 2014.

UBS strategist Joakim Tiberg estimates the Australian dollar’s value would be 78 US cents when iron ore is at $US65 a tonne. The currency’s value jumps to more than 85 US cents if iron ore climbs to $US80 a tonne and drops to under 70 US cents if iron slips to $US50 a tonne.

Volatile

While Iron ore has had a volatile 20 months or so, the Australian dollar has remained resilient as the outlook for the price of the metal hasn’t budged much. Currency traders focus more on the commodity forecasts than spot prices.

Iron ore slumped to a low of just over $US 38 in December 2015, then steadily rebounded until it reached a two –and-a-half-year high $US95 in February 2017.

In that period, the Aussie has traded primarily largely between 73 US cents to 76 US cents. It dropped briefly below 70 US cents in January last year as a weaker Chinese economy coupled with improving prospects for in US weighed on the currency.

As iron ore prices dropped almost 40 per cent from the peak to record the steepest three-month drop since a 58 percent collapse through November 2008, the currency followed suit.

The Australian dollar was the worst performer in a basket of 10 developed market currencies in the June quarter. It dropped 0.5 per cent in the three months ended June 30.

Since then, fortunes have reversed. Iron ore has breached $US70 a tonne again to reach its highest level since April 11. And the Australian currency promptly responded by surging above 80 US cents in July, for the first time since May 2015.

“Looking ahead, we can expect a decent rise in the terms of trade to be recorded in the third quarter, given that market prices for iron ore have been rising again,” Ben Jarman, senior economist at JPMorgan says.

Differentials

To be sure, the currency was also helped by a broad-based US dollar weakness following a dovish monetary policy statement from the US Federal Reserve and slowing inflation growth in the world’s largest economy.

Still, interest rate differentials can turn negative with the RBA clearly indicating it is on hold while the US fed maintains its tightening stance. The last time, US bond yields offered a premium to their US peers was in the year 2000.

Diverging monetary policy meant the premium the Australian two-year notes offer over similar-dated US Treasuries shrank last month to just 24 basis points.

That was the lowest since 2001 and back then, the currency slumped to an unprecedented 47.76 US cents. The spread has since widened after lukewarm US economic data and traders starting to question the ability of the Trump administration to push through reforms to spur growth.

However higher commodity prices, which in turn are boosting trade surplus and narrowing current account deficit, mean  interest rate differentials matter much less than before.

To use an example, Japan had negative rate differentials to the US for years. Yet the yen has maintained a lot of strength; the big cycle changes in the yen have been driven by changes in Japan's current account balance.

ANZ’s head of forex research Daniel Been in a note to clients in June said he didn’t think the narrowing in bond spreads can, in isolation, drive the Australian dollar back below 70 US cents.

“We think that rates represent only a part of the story. The terms of trade, liquidity and valuation dynamics all look very different to the 2001 experience,” he says.

“The evolution of global liquidity and the reaction of risk markets will be the key determinant. For now, and across our forecast horizon, we think that both of these factors remain supportive.”

Narayanan Somasundaram is a freelance economics & finance reporter