The overheated Aussie needs to be cooled quick

THE Australian dollar (Aussie) has been riding a tsunami wave over the last few years. Since lows at the end of 2008, the currency has rocketed by nearly 75 per cent against the US dollar. But as Asian economies realign, its rise looks set to end, bringing downward pressure on the currency.

Commodities play a significant role in Australia’s economy, and the Aussie’s rise has been fuelled by demand from emerging markets in Asia. The currency has previously enjoyed a strong correlation with resources, such as iron ore, and was used as a proxy by investors to gain exposure to markets like China, its biggest export partner.

Over recent years, Asian economies have kept their currencies artificially weak to ensure their exports remain attractive. But as these contries move away from investment and export-led growth models, and gear towards domestic consumption, this may no longer be necessary. This is beginning to impact the Aussie, breaking down its strong correlation with commodities (see chart).

As trade from emerging markets slows, Australia’s current account could be hit. Due to softer global demand, the Organisation for Economic Co-operation and Development (OECD) has subsequently cut its GDP forecast from 3.7 per cent to a still respectable 3 per cent.

As iron ore prices stabilise, and export volumes continue to grow, the OECD estimates that mining will still expand “vigorously” in 2013. In a note, UBS has argued that this may carry on “as several years of mining investment feeds through to greater export capacity”. But the danger is that the extra capacity will not be soaked up, pushing prices lower.

Away from mining, the Australian economy is less robust. In response, the Reserve Bank of Australia (RBA) has slashed its cash rate (its base rate) to 3.25 per cent, from 4.5 per cent a year ago, which has helped cool the rise of the currency. And there may be more cuts on the horizon, perhaps as early as December. UBS has said that “more rate cuts could follow if non-mining sectors of the economy do not revive in time to pick up the slack,” which will add to the downward pressure on the Aussie.

The RBA hasn’t engaged in any outright quantitative easing, like the Bank of England and US Federal Reserve. However, rumours have been circulating that it is “passively” intervening, by stepping up the pace that it is acquiring foreign currency reserves (that it uses to buy foreign bonds).

Official data shows that the RBA is now buying approximately Au$450m (£294m) of foreign currency per month, up from around Au$100m per month over the last year. This has undoubtedly contributed to recent Aussie weakness. Even though RBA governor Glenn Stevens played down the accelerated pace, UBS said that it shows that the Aussie “is high enough [for the RBA] to allow accumulation of foreign reserves on its balance sheet”.

Inflation is expected to come in at 2 per cent this year. But looser monetary policy and a weaker Aussie may stoke it. This is not a point not missed by Stevens: “A lower exchange rate would need to be accompanied by a pace of growth of domestic costs below that seen for much of the past five years, in order to maintain low inflation.”

Brave traders may be tempted to use the Aussie as part of a carry trade, which is where you borrow money in a cheaper currency and invest that money in a higher yielding currency, typically by parking the cash in bonds. “The Aussie carry is starting to look very attractive against several currencies, but especially versus euro,” says Morgan Stanley. But the euro can be volatile, so it is not a trade for the inexperienced.

And in the short-run, the Aussie is likely to be supported by better economic data coming from Asia. The latest Chinese manufacturing purchasing managers’ survey is showing expansion for the first time in over a year, which has helped to support the Australian dollar. But over the medium term, the Aussie’s prospects look grim.

Morgan Stanley expects Aussie-dollar to fall from its current price around $1.04 to the $0.96 level by the end of 2013. UBS has a similar view, saying that it “expects the Aussie to drift lower towards parity over coming months.”

By the standards of most countries, Australia’s economy is relatively strong: low unemployment, combined with real growth over the next few years is enough to make most Western economies envious. But despite this strength, macroeconomic factors in Asia, along with a looser monetary stance from policymakers is likely to weigh on its currency. Therefore, in the medium term, the Aussie looks like a prime target for traders to go short.