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Monday, March 24, 2008

Outlook for the AUD - a brave man's forecast

Reading some commentary on the Australian dollar I seem to be at odds with most of them. The SMH asserts “The Australian dollar may fall 7% in the next two months as commodity prices weaken and global equities decline”. The AUD reached a one-month low of USD90.97 last Thursday, down from its high of USD94.98 on 29 Feb 2008 – last reached on 29 March 1984. The argument for a weaker AUD is “The commodity story from here will be mixed to negative and risk appetite is being unwound”. On that note I am in wonder – where is the risk:
  1. Commodity prices are resilient because of the weak USD. Where is the compelling evidence for a stronger USD? I can see some weakness for commodity prices but not a great deal.
  2. Commodity prices are mostly (coal, iron ore, bauxite) sold forward on 1 year annual negotiations and prices are higher than last year along with volumes
  3. Agricultural commodities are set to be a contributor since the drought-breaking rains last year, so might we expect added zest to the AUD on those export flows
  4. Australian consumer confidence has slumped so we can expect weaker imports
  5. The spread with Japan is even better at 6.75% since the BOJ is offering 0.5%. You might think this is a problem because Australia is a commodity currency, but consider markets are driven by yields and capital growth. I don’t see much prospect for capital growth in the current market, so I am confident the AUD will get supported on the basis of yields. Why else would you buy bonds?
  6. Australia’s public debt as a % of GDP is the best in the developed world at just 15% of GDP. The only positive legacy of the Liberal Party. That gives the current government a lot of capacity to soften any downturn with public spending. One might make the argument that Australia has huge private debt, but its mostly real estate stock and it could be readily absorbed by higher migrant inflows. I would not be surprised to see the Australian Labor government lift immigration intakes, though it will need to pay off the Greens with more national parks and windmills.
  7. Australia is one of the governments that has raises interest rates, so preserving the attraction of the AUD for the Yen carry trade. The cash rate for the AUD is 7.25% after the RBA raised rates this month – thats a 5% spread over the Fed’s 2.25% on March 18.

I have just one qualification – money supply growth in Australia based on statistics I downloaded on the weekend is very high. In fact its at historic highs. The positive implication is likely to be that the Australian government will reign in that money supply by raising rates, at a time when the Fed could possibly lower them more. The USA is going into recession, and more importantly it faces an election.

“Risk aversion remains the dominant factor holding back the Aussie against the US dollar” according to Commonwealth Bank chief currency strategist Richard Grace. I don’t disagree with this, but that is the basis of buying opportunities. The reality is that no where is there growth prospects, so true no one is looking for growth from Australia, however I think the agricultural sector will surprise the market. I also think yield rules in these conditions. Australia is also a significant natural gas exporter and commodity prices in US terms still look good if you agree that the USD is going to its all-time low of 85Yen. I would suggest that Australian commodity export capacity is alot more tangible than the USD banking system. The gold sector is going to be another great performer for Australia in coming years. The other factor supporting the AUD is likely to be efforts by Asian governments to boost their domestic economies in the wake of a weakening US economy. Its worth considering the capacity of Asian governments to do this:

  1. Australia – public debt 15% of GDP – but high external debt
  2. China – public debt 21% of GDP
  3. Korea – Its public debt is 23.8% of GDP
  4. USA – Its public debt is 36% of GDP - but high external debt
  5. UK – Its public debt is 43% of GDP
  6. Canada – Its public debt is 55% of GDP
  7. India - Its public debt is 58% of GDP
  8. Germany - Its public debt is 65% of GDP
  9. France - Its public debt is 66% of GDP
  10. Taiwan – 121% of GDP
  11. Japan – the Japanese public debt is 182% of GDP

If anyone has the capacity to lift spending its probably the USA, but I don’t expect it at a time of rising global inflation. I think the Democrats will raise taxation.

Lastly I want to reiterate - I dont see depreciation - but there will be alot of pain for holders of debt that is not fixed. You should have fixed your property loan rates, at least for the next 5 years.

Andrew Sheldon


Chee said...

Wow, would you say RSA will raise rates further with its huge money supply. Knowing the rising trend of AUD that is confirming your forecast as of today, do you see AUD/JPY breaking its highs over a relatively stronger JPY now?

I have an unfixed JPY loan for 15 years. Its a small amount and I can easily pay it off should the rates rise too much. But looking at Japan, it just looks like it will stay 0.5-2% the most even for 15 years. What do you think?

And what are implications of Japan's very huge public debt?

Andrew Sheldon said...

sorry Chee, I can't comment on your loan since I dont know when you made the post. As far as Japanese public debt, its owed to Japanese people. Foreigners dont buy Japanese bonds because of meagre return. The implication is that the Japanese government/BOJ has little capacity to stimulate the domestic economy with fiscal policy. Clearly they are not resorting to monetary stimulus or economic reforms. Fact of the matter is - all they are doing is playing musical chairs with prime ministers.

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