Analyzing the Australian Dollar - Up, Down, and Under
From the outside world, trading in the arcane foreign exchange markets might appear to be quite glamorous. However, attempting to make a living in the sleepless FX market can often become injurious to one's mental health or pocketbook, where schizophrenia often seems to be the rule of the day. Yet for all the daily madness surrounding the FX market, when staring at the weekly price charts for the Euro, yen, pound or Aussie dollar, the outside observer will also notice methodical and established trends that can last for months or years.
Although trading in the Australian dollar might not be a glamorous as dealing in the Euro, British pound, or Japanese yen, it is a most fascinating currency because of its historical relationship to gold and the broad commodities markets. From 2002 to late 2005, the Aussie dollar displayed an amazing 96% degree of correlation to the direction of the US gold price. For the 12-months ended June 2005, the Aussie traded with an 82% degree of correlation with the price of copper.
The Australian dollar is the fifth-most-actively traded currency in foreign exchange markets today, behind the US dollar, Euro, Japanese yen, and British pound, accounting for 5.5% of the volume in the $1.9 trillion dollar per day market. The Aussie dollar is popular with currency traders due to a relative lack of central bank intervention, the general stability of the economy and government, and it lends greater exposure to Asian economies and the commodity super cycle.
But in order to trade the Australian dollar successfully, it is helpful to know about its history, some basic economic fundamentals, the role of interest rate differentials, and trader psychology surrounding the currency.
In 1983, Canberra abandoned its managed peg for the Aussie dollar, which was tied to a basket of foreign currencies, and opted to float the currency in the open market. Within 2-years however, the Aussie dollar suffered a massive 30% devaluation before finding some stability near 70 US-cents in 1985. But throughout its 23-year history as a "free floater", the Aussie dollar has usually served as a proxy for gold, and often carried a bonus as a high yielding currency. (That historical relationship broke down in late 2005, and will be explained later in this article).
Typically, the higher yield on Australian deposits would help offset losses to foreign investors when the Aussie and gold fell, and conversely, padded gains when the Aussie rallied into higher ground. The trick for currency traders was to buy the Aussie when the currency and gold showed signs of stability, and sell quickly when the gold market looked toppy. Due to the thinness of the market, the Aussie could move 1-2% in a single day, so traders had to be quick on their feet
The price of gold touched new highs on Feb 2 nd, 2006, bursting through the Australian dollar record set 26-years ago. Gold hit $AD766.02 an ounce on the spot market touching the previous record of $AD766 set on January 21, 1980 when gold hit $US850 an ounce and the Australian dollar was worth $US1.1097. While gold is traded in US dollars, the Australian-dollar price is more important to Australian producers because it is the margin between their Australian-dollar costs and the Australian-dollar price they receive for their gold that determines their profitability.
In 2004, Australia produced 261 million tons of gold, second only to South Africa. Yet of the dozens of listed gold companies on the Australian Stock Exchange, only a few actually mine, produce and smelt the majority of Australia's gold production. So it is easy over-estimate gold's influence on Australia's economy. Gold producers only employed 11,251 people in 2004. But it is the flow of capital from abroad, moving in and out of Australian mining companies that influence the Aussie on a daily basis.
Newcrest Mining, NWC.AX is the biggest Australian owned gold miner and its second-quarter gold output rose 71% to 430,000 ounces in the fourth quarter of 2005, largely due to its Telfer mine in Western Australia. Copper production rose to 28,325 tons, from 18,439 tons. Australian gold and base metals miner Oxiana OXR.AU produced 228,002 ounces of gold in 2005 and expects about the same output this year. Full-year copper production was 53,547 metric tons and zinc production was 72,761 tons. Foreigners have already taken over Australia's two other gold miners, Normandy Mining and Aurion Gold.
Amid of storm of controversy, the Reserve Bank of Australia actually contributed to the demise of the Aussie dollar in the first half of 1997, when it sold two-thirds of its gold reserves in the first half of 1997, near a 20-year low for the yellow metal. On July 3, 1997, the RBA announced, "Over the past six months, the Reserve Bank has sold 167 tons of gold, reducing its holdings from 247 tons to 80 tons." The RBA said it planned no further gold sales, but was widely accused of betraying local gold miners, undermining the gold price and the Australian economy.
Gold mining shares soon plunged, the Australian stock market tumbled, and gold skidded to its lowest level since 1985 to $325 per ounce. The gold sales soured currency market psychology, and toppled the Aussie from 81 US-cents level to as low as 55 US-cents a year later. To offset the pain in the equity markets, RBA governor Ian McFarlane guided the 3-month Aussie deposit rate lower from 7.00% to 4.50%, but also greased the skids under the Aussie dollar from 1999 to early 2001.
RBA governor Ian Macfarlane argued that gold was a poor investment. He said taxpayers were losing about $150 million a year in potential investment income with the gold price falling. The RBA made some $2.4 billion from its gold sales. The Bank of England made the same arguments in 1999 to justify its gold sales.
By early 2001, The Aussie dollar had fallen below the psychological 50 US-cents level, while the Bank of England was pounding the gold market with a series of 17 auctions, part of its campaign to sell 340 tons of gold, or two-thirds of its gold reserves. The price of gold continued to fall, hitting a 20-year low in August 1999 of about $256 per ounce, depressed by the Bank of England's gold auctions.
Finally, the RBA decided to defend its currency and bought 3.6 billion Aussie dollars near 50 US-cents to fight off bearish speculators. Meanwhile, the sharp drop in Australian interest rates engineered by the RBA had touched off a local housing boom. Real estate prices in upscale neighborhoods in Sydney jumped 23% in the first half of 2002. The housing boom had insulated Australia from a global slump that sent its two biggest export markets, the US and Japan, into recession in 2001. The Australian economy grew 4.1% in the fourth quarter 2001 from a year earlier.
On March 5th, 2002, the Bank of England held its last of its 17 gold auctions, dumping 20 metric tons of gold at $296.50 an ounce, below the spot rate but the highest price earned since its auctions began in July 1999. The Aussie dollar opened for trading at 52.04 US cents the next day and never looked down under again.
Then a week later on March 20th, 2002, the Reserve Bank of New Zealand surprised currency traders by upping its benchmark interest rate a quarter-point to 5.00% and warned that further hikes would be needed to curb inflation. In those days, the RBA and RBNZ co-ordinated their monetary policies, due to the close synchronization between their export oriented economies and a desire to maintain a stable Aussie/NZ kiwi exchange rate.
On May 8th, 2002, The Reserve Bank of Australia followed suit, and raised interest rates a quarter-point to 4.50% for the first time in 19 months, aiming to cool what it called an "overheated housing market", marking the opening salvo in the bank's campaign to tame inflation. At that point, Aussie deposit rates were 275 basis points above comparable US dollar rates, and the Aussie had already rebounded to 57 US-cents and on its way to a multi-year rally against the dollar and Japanese yen.
Beyond its relationship to gold, the Aussie dollar is also regarded as a "Commodity Currency" along with the Canadian and New Zealand dollars, and the South African rand. Australia is the world's biggest exporter of hard coking coal, the type used by steelmakers, which jumped 120% to $125 a ton in the year beginning April 1st 2005. Iron ore prices were hiked by 72% in the same period.
Commodity sales are expected to total AD$114.6 billion in the year ending June 30th, 2006, or about 55% of the country's exports, according to the Australian Bureau of Agricultural and Resource Economics. Sales to China improved by 48% in the final four months of 2005 compared to the previous year. Raw materials account for almost 60% of Australia's exports, and with the soaring prices of precious metals and aluminum and copper, Australia was able to cash in last year.
Exports of metal ores and minerals rose 27% or $AD592 million, where the largest increases were in copper ores, up 304% or $AD357 million, aluminum oxide up 21% or $78 million, and zinc, up 45% or $AD42m, both largely on increased volumes. Metals excluding gold were up 22% or $AD188 million where the largest increase was in aluminum, up 55% to $AD196 million. Australia's Zinfifex, ZFX.AX is the world's second largest zinc miner behind Teck Cominco in Canada.
Australian exports of goods and services to China in 2005 rose to $15.3 billion, replacing the US as its second-biggest buyer, due to China's rapid industrialization. Apart from China's huge demand for Australian minerals, Taiwan, Japan and Korea are also paying more for these minerals. China's share of Australian exports was 9.4%, still well below Japan's $28.2 billion or 17.3 % of exports. The US fell into third place with $13.9 billion or 8.5% of exports.
Although the value of Australian exports rose 7% to a record in December, Australia ran a trade deficit of $AD1.6 billion during the month, extending the nation's run of trade gaps to 45 months, the longest since the 56 months ended February 1985. Overall, Japan remains Australia's #1 trade partner, with total trade, or imports and exports, between the countries valued at $47.3 billion. The US is #2, with trade worth $41.5 billion, and China is third with $36.3 billion.
But having the status of a "commodity currency" is also symptomatic of Australia's boom and bust growth cycles. The Australian dollar's appreciation above 70 US-cents in the past few years is hurting the majority of nation's exporters, an Australian Industry Group survey said. "The study demonstrated that 65 US-cents and 70 US-cents were significant trigger points at which a range of Australian products would become uncompetitive. Current exchange rate movements have therefore clearly moved the dollar into danger territory for Australian business," the AIG said.
The Aussie dollar appreciated by as much as 42% to as high as 91 Japanese yen from its low of 63-yen in the third quarter 2002. Japanese traders played the "yield carry" game, borrowing yen in Tokyo at zero percent, and re-lending the funds in Aussie dollars, at a higher yield of 5.50% for short term deposits. Japanese bankers earned a positive rate of return on the carry trade for 3-½ years, while enjoying a significant currency gain to boot.
Most interesting is the interplay of capital flows versus trade flows in currency markets. Here, the Australian dollar is saddled with a long string of trade deficits, and yet, appreciated against the Japanese yen, which enjoyed a trade surplus of 7.6 trillion yen ($64 billion), and an investment surplus of 11.4 trillion yen ($97 billion) in 2005. Australia's interest rate advantages over Japanese rates were wide enough to fund a massive trade imbalance versus Japan's yen.
But Japan is Australia's largest export market and the overvalued Aussie/ yen exchange rate has stymied Australian businesses outside of the resource sector. The resources boom is dividing the Australian economy into two tales. The resources boom extends employment and housing in the resource rich regions, such as Western Australia, much of Queensland, and also parts of South Australia, where BHP Billiton is exploiting the Olympic Dam project.
But with alongside prosperity in the west, there is stagnation in the industrial capitals of Sydney and Melbourne. In the western suburbs of Sydney, unemployment has risen over the past year from 8.2% to 9.9 per cent. The outer western suburbs of Melbourne have suffered an increase in unemployment from 5.5% to 7.8% over the last year. The industrial suburbs of the east are being hurt by a higher Aussie exchange rate against the Chinese yuan, which is pegged to the US dollar, and is making Chinese imports super competitive in the local economy.
The RBA has held its cash rate steady at 5.50% for eleven straight months, a level considered neutral for the overall economy, but too high for manufacturers struggling against Chinese imports and households that have unprecedented debt levels. The Commonwealth of Australia's Housing affordability index is measured at 104.00, well below its high of 176.3 in September 1997, and not too far from its recent low of 97.8 reached in December 2003/
The housing affordability index is measured by a ratio of the average household disposable income required to meet the payments on a typical dwelling. Without the resource boom in the west, the housing markets in the east could suffer much bigger subsequent falls in home prices, with consumer spending falling so far that the economy could be pushed into recession. This was the experience of Australia at the end of the 1980's, and also Britain, Sweden, Japan and Hong Kong.
While official interest rates are set at 5.50%, their highest in four years, standard variable interest rates for housing hover around 7.3% after lenders add a profit margin. However, borrowers can fix longer term interest rates below 7%, depending on the lender and the length of the fixed period.
If it wasn't for the mining boom, Australia's economy might be teetering with recession, slowing from the end of the house price boom, high oil prices, and high interest rates that are negatively affecting retail spending, core manufacturing industries, and housing construction.
After meteoric employment gains in 2004 and the first half of 2005, Australia's jobs boom is clearly over. In January, the national jobless rate edged up 0.1% to a 15-month high of 5.3%, a one year high with no employment growth for the past six months. And history shows that the Reserve Bank is usually quick to lower interest rates once the unemployment rate turns up significantly.
In the Australian credit markets, an inverted yield curve has been evident for the past 12-months, with the 10-year Treasury bond yielding 23 basis points less than the 3-month bill rate. The appearance of an inverted yield curve suggests the next RBA move on rates could be to the downside. Thus, the inverted yield curve has also served to blunt the Aussie dollar's advance against the US dollar, and ushered in a downward sloping trend to under 74 US-cents, when booming gold and commodity prices would otherwise point to a sharply higher Aussie dollar above 80 US cents.
The Australian dollar is also losing its interest rate advantage over US dollar deposit rates, contracting to a five-year low. The Reserve Bank's overnight cash rate target is 5.50% compared with the US fed funds rate of 4.50 percent. Yields on Aussie December 90-day bank bill interest-rate futures contract were last seen at 5.55% suggesting that RBA rates will remain unchanged or slip this year.
The yield on the Aussie's six month deposit rate has declined to a 64 basis points premium over US dollar rates, well below its high of 440 basis points two years ago. The new Fed chief Ben Bernanke is widely expected to hike the US fed funds rate a quarter-point to 4.75% in late March, to brush-off some of his dovish feathers, narrowing the interest rate differential with the RBA a bit further.
If the Fed rate hike contributes to hedge fund liquidation in commodities, then the Aussie dollar could get hammered by two fronts, and fall towards its 2004 lows of 68 to 70 US-cents. However, if the Fed rate hikes triggers a bursting of the US housing bubble, the US central bank could spend the rest of 2006 looking for ways to lower the fed funds rate, supporting the Aussie dollar. Traders should watch the trend for US housing stocks for real time clues on the wealth of the US consumer.
Traders will also be on the lookout for the Bank of Japan, which is making noises about tightening its monetary policy after April 1st. The slightest whiff of a tighter BOJ policy could trigger unwinding of the Aussie /yen carry trade, with Japanese traders dumping Aussies and swapping back into yen. Hedge funds might also lighten up on leveraged positions in commodities financed in yen. Indeed, the February sell-off in the CRB index coincided with a sharp sell-off in Japanese interest rate futures contracts in Singapore, lifting the yield on Japanese yen deposits for June delivery from 0.42% to 0.52 percent, anticipating a tighter BOJ policy.
The demand for the Aussie dollar is also influenced by the direction of base metals and crude oil prices, which in turn, impacts demand for Australian resource shares like BHP Billiton (BHP), Rio Tinto (RTP ,) Zinifex (ZFX.AX), and Woodside Petroleum (WPL.AX). BHP and Rio Tinto have already dropped 10% and 9.6%, respectively, since peaking on January 30 th. Rio Tinto posted a record second-half profit on Feb 2 nd, but the share price had already discounted a lot of good news. Traders then began to acknowledge heavy hedge fund liquidation in base metals.
The direction of commodity and gold prices and their impact on trade flows, interest rate differentials with the US, Japan, and other countries, and the demand for Australian resource shares, are all key variables moving the Aussie dollar.
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