Australian Dollar: a High Beta to Global Risk Appetite, Along with a Close Correlation to Commodity Prices, May Cause Further Volatility for the Australian Currency

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Australian Dollar: A high beta to global risk appetite, along with a close correlation to commodity prices, may cause further volatility for the Australian currency

Rising interest rates, accelerating commodity prices, and relatively robust domestic economic data have helped the Australian dollar rise strongly versus other currencies, especially the U.S. dollar. With a close correlation to global risk appetite, investors should be aware of the positive and negative factors that could affect the currency going forward.

Positive catalysts have caused the Australian dollar to rise below). Benchmark interest rates are 4.5% in Australia, compared strongly since early 2009 with just 0.1% in Japan and as low as zero in the U.S. This interest Australia’s currency has enjoyed strong gains over the past year rate differential remains a significant positive for the Australian (figure 1, below). The decision by the Reserve Bank of Australia currency, although this may diminish as expectations for rate (RBA) to begin tightening monetary policy in October 2009 (the rises in the rest of the world gather momentum. first developed world central bank to do so), along with a strong Figure 2: Large interest rate differentials compared with other recovery for its own domestic economy, has caused the currency central banks to rally strongly. However, the strength of the currency also reflects Short-Term Interest Rate Forecasts the close correlation that the Australian dollar has to global risk U.S. Euro Area U.K. Japan Australia appetite. Its strong rebound through much of 2009 (in an early Current 0.25% 1.0% 0.5% 0.1% 4.5% economic cycle environment) has been very much a response 2011 0.7 1.1 1.0 0.1 5.5 2012 1.8 1.5 2.0 0.3 5.8 to the rebound in Chinese demand and the resulting upgrades 2013 3.0 2.3 3.0 0.7 6.0 to commodity prices. These forces—rising interest rates, rising 2014 4.0 3.0 4.0 1.2 6.0 commodity prices, and a robust domestic economy—are still at Average Last 10 Years 3.2 3.0 4.4 0.1 5.3 play. However, the relative benefits of some may begin to fade, Average Last 20 Years 4.1 N/A 6.0 1.5 6.3 depending on how the global economy performs going forward. Source: Citigroup

Figure 1: Australian dollar has risen strongly against the U.S. dollar The rally in the Australian dollar throughout 2009 can also Data to 17 September 2010 1.05 be attributed to the sustained depreciation of the U.S. dollar. A$ vs. U.S.$ However, there was evidence in the first quarter of 2010 that 0.95 this had started to show some signs of reversal as U.S. economic data improved and yields on U.S. Treasuries rose. Markets started 0.85 to consider the possibility of higher official interest rates and the

0.75 reversal of the significant market liquidity programs.

0.65 Recently, however, indications that the pace of the U.S. economy’s growth has lost momentum this summer, while the rate of 0.55 inflation has fallen sharply at the same time, have moderated these expectations. In fact, with the U.S. Fed stating that the 0.45 outlook was “unusually uncertain,” consensus for the first

Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 interest rate hike has now been pushed out from early 2011 to Source: Bloomberg the fall of 2011. If that prediction is accurate, we may continue to see a strong Australian dollar versus its U.S. counterpart. Outlook: A mixture of factors may affect Australia’s currency going forward Australia is extremely advanced (and anomalous) in this particular interest rate cycle, with most other developed

marketsSep-97Sep-98 maintainingSep-99Sep-00Sep-01 a verySep-02 looseSep-03 monetarySep-04Sep-05Sep-06 policySep-07 (figureSep-08 Sep-092 , Sep-10 We do, however, have to take into consideration that on an Current implications for Australian monetary policy historical basis, the Australian dollar has been trading at the 60 Following a period of unprecedented easing over eight short upper end of its trading band over the last year. This dovetails months, which brought official policy rates down to all time 40 well with the upturn in equity prices and global risk appetite. lows, the RBA has been one of the first central banks to tighten

With its peak in recent years being 0.9798 (15 July 2008), 20 monetary policy. However, despite six rate hikes since October coinciding with the peak in equity markets, it can be argued that 2009, the current cash rate is still slightly below what historically if we see both risk assets and equities prosper going forward,0 has been considered neutral (figure 5, below). then there could be further upside for the currency. But if we encounter a period of uncertainty, then you could see the -20 Going forward, however, the RBA is maintaining a more currency fall in line with sentiment. cautionary stance. At recent meetings, the RBA intimated that -40 Chinese economic growth was “moderating to a more sustainable rate as policies are now less accommodating,” indicating less Resurgence in domestic economic activity -60 Australia’s currency also has benefited from a resurgence in chance of upward risk from China. With monetary policy close to its own economy. Employment has rebounded strongly, rising more normalized levels, inflation “close to target,” and economic 4” diﬀerence job advertisements point to further gains in the short term growth likely to be close to trend, policy should remain relatively (figure 3, below), and wage growth has returned to pre-crisis stable4” diﬀerencein the short term. As for the crucial “medium-term,” the rates. Improved consumer confidence and the swing in Australia’s RBA has stated that inflation will be the crucial barometer to trade balance into surplus also have provided a fundamental flow monitor. Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 Jun-10 of support for the Australian dollar. If this continues, it would Figure 4: Australian dollar cycle is closely aligned with the provide a positive backdrop for the currency. prospects for commodity prices 1.1 350 Figure 3: Australia’s labor market is recovering strongly 5% 60% 1.0 Employment, YoY% 275 Job Adverts, YoY%, 6m lag (Rhs) 4 40 0.9

3 20 0.8 200

2 0 0.7 125 1 -20 0.6 A$ vs. U.S.$ (Lhs) Westpac Commodity Futures Index (Rhs) 0 -40 0.5 50

“3.00” 4 Jul-10 -1 “3.25” 4 -60 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 “3.50” 2 Source: Bloomberg “3.75” 3 Oct-00 Oct-02 Oct-04“4.00” 1Oct-06 Oct-08 Jun-10 Source: Credit Suisse Figure 5: Australian monetary policy closer to historical averages “4.25” 5 45 “4.50” 7 Blue represents average range of cash rates. “4.75” 40 40 The outlook for commodities,“5.00” and 26 subsequently economic Histogram of RBA Cash Rate growth in China, are key factors“5.25” for 21 the Australian currency 35 “5.50” 20 “5.75” 8 Perhaps one of the most important factors to monitor in recent 30 “6.00” 13 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 years has been the future of“6.25” commodity 17 prices. Using the 25 Westpac Commodity Futures“6.50” Index, 4a measure of futures trade Oct-00 Oct-02 Oct-04“6.75” 4Oct-06 Oct-08 Current cash rate 20 commodities, we can see that“7.00” the Australian 4 dollar’s relationship can be considered “7.25” 6 Dec-0515 “neutral”Dec-06 based on Dec-07 Dec-08 Dec-09 Jul-10 with its U.S. counterpart is closely“7.50” linked 21 with the performance of lending rates “More” 0 commodities (figure 4, next column). Therefore, with China being 10 the main driver of commodity prices in recent years, the outlook observations Number of monthly 5 for the Chinese economy will be paramount in assessing the 0 prospects for the Australian currency.

3.00 3.25 3.50 3.75 4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25 6.50 6.75 7.00 7.25 7.50More Source: Citigroup

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“3.00”“3.25”“3.50”“3.75”“4.00”“4.25”“4.50”“4.75”“5.00”“5.25”“5.50”“5.75”“6.00”“6.25”“6.50”“6.75”“7.00”“7.25”“7.50”“More” How does this impact global equity investors? Adopting a 50/50 split between a hedged and unhedged For those investors who have sought to diversify their positions by portfolio could also prove beneficial for investors, especially when the currency is trading in a relatively small trading range. This allocating money to global equity markets, any increase or decrease would also allow for the flexibility to make a strategic tilt when in the value of the Australian dollar will have a respective negative parameters for the currency are close to being reached, have been or positive impact on investment returns. This would argue for a reached, or have been breached. However, execution of this may global portfolio to be hedged against any fluctuations in the value prove difficult as currency markets can move very quickly. Therefore, of the currency. choosing a global equity manager to manage these currency risks may offer the best option. However, what investors should perhaps assess is how leveraged they wish to be to their own domestic economy. With Australian Importantly, however investors choose to invest, advisors should stock markets being predominately made up of financials and always remain fastidious in their duties irrespective of the economic climate and selection should always be based on a natural resources companies, China, and the prospects for its multitude of factors. Attributes such as durability of investment economy, plays an important role for many Australian stocks. A process, robustness and independence of fundamental research, hedged global portfolio would only add to this bet. By contrast, an quality of risk controls, consistency, etc., are very important to unhedged portfolio offers the opportunity to properly achieve those scrutinize in the selection process. Above all, however, advisors are diversification benefits sought in the first place, especially when supposed to be fiduciaries, they are guardians of a trust and should paired with a domestic equity allocation. always put clients’ interests first.

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