More bad news for expats: the Aussie dollar will stay strong

A favoured play on the growth of the Chinese economy and the commodity boom, there is little chance of the currency hitting fair value

PUBLISHED : Wednesday, 29 August, 2012, 12:00am
UPDATED : Wednesday, 29 August, 2012, 9:25am

"What's going on with the Australian dollar? Why is it so strong?" asks a colleague who wants to transfer money down under. "Surely it should be much weaker than this?"

She has a point. For most of the last 10 years the aussie has been a favourite play on both the growth of the Chinese economy and the commodity boom.

As a result, between 2001 and 2011, the aussie more than doubled in value against the US dollar, hitting a 30-year high of US$1.10 last month.

Since then, however, Chinese growth has slowed, and China's demand for Australian minerals has softened.

In the last few weeks the price Chinese importers are prepared to pay for iron ore has slumped to a three-year low, while Anglo-Australian mining giant BHP Billiton has suspended investment projects worth tens of billions of US dollars on worries about further declines in the prices of industrial metals.

Yet despite the bad news, the Australian dollar has remained stubbornly strong. As the first chart shows, while the non-ferrous metals index compiled by the London Metal Exchange has fallen by 18 per cent over the last 12 months, the aussie has slipped just 2 per cent.

At an exchange rate yesterday of US$1.04, the currency is looking so resilient that some analysts are worried its strength may begin to damage Australia's economic prospects.

"Really, it is a bit on the high side," admitted Glenn Stevens, the governor of the Reserve Bank of Australia last week.

He's putting it mildly. As the second chart below shows, the aussie is trading 33 per cent above its fair-value "purchasing power parity" rate of 70 US cents, making it the most heavily over-valued of all the major tradeable currencies.

"Something funny's going on," my disgruntled colleague complains. She's right, but it's going on in Europe, not Australia. As Europe's debt crisis has deepened, an increasing number of traders and investors have decided that the euro is likely to weaken and that there is money to be made by selling it short.

When shorting a currency, traders normally sell it against the US dollar. But with the American economy weak, Washington's fiscal situation increasingly ugly, and calls mounting for a fresh round of money printing by the Federal Reserve, enthusiasm for holding US dollars is limited.

As a result, people have looked around for an alternative, and latched on to the Australian dollar as the ideal safe-haven long to offset their short position in the euro.

The Aussie's advantage is obvious. Australia is just one of seven countries with a sovereign credit rating of AAA from the three major ratings agencies. Yet unlike the others, Australian assets offer a relatively high yield. Australia's 10-year Commonwealth Government Securities carry a yield of 4.4 per cent. That's more than four times the meagre 1 per cent yield on equivalent Swiss government bonds, the traditional safe haven investment.

As a result, foreign investors have flocked to load up on Australian government debt, buying A$62 billion (HK$499 billion) worth over the 12 months to March. According to Gerard Minack at Morgan Stanley in Sydney, foreigners now own 77 per cent of the entire stock of outstanding Commonwealth Government Securities.

And they've done well on the trade. According to Bloomberg, over the last 12 months a short euro-long Australian dollar position would have made a return of 17 per cent. That compares with a return of minus 2 per cent on a long position in the Swiss franc against the euro.

As a result, it would take a big improvement in sentiment towards Europe to trigger the major fall in the aussie my colleague is hoping for.

Some observers believe that may be about to happen. European stock markets and the euro have both made modest gains in recent weeks, while the aussie has slipped a bit.

But the European crisis is still a long way from being resolved. As a result there appears little chance that the aussie will be heading back to fair value at 70 US cents any time soon.