What the recent rise in the Aussie dollar means for investing
Market attention in July and August was—unsurprisingly—focussed firmly on the path of the Australian dollar (AUD). After it broke free from its 18-month bind of 72-78 US cents in July, speculation increased as to its likely future relative to the US dollar (USD) – and what that meant for investing. Although the currency strength began to unwind in September, at month end it was still trading over nine per cent above its low in December 2016.
It’s important to understand what’s behind the rise in our dollar
It is largely being driven by a weaker USD. And that’s fallen due to investors losing confidence in the ability of both the US Federal Reserve to deliver future rate rises, and for the Trump administration to deliver promised economic and tax reform. In fact, the USD fell by nearly three per cent over the three months ended September against a weighted basket of currencies. In addition, a bounce in iron ore prices and speculation that the Reserve Bank of Australia (RBA) may seek to raise rates also contributed to our dollar breaking above US 78 cents.
There are several reasons that may see a reversal in its fortune
While the above-mentioned factors may well see some further resilience in the AUD in the immediate term, currency movements are extremely difficult to predict with any accuracy over short time frames. However, there are a number of reasons why we believe the AUD should further weaken against the USD over the medium term, and as such, we remain bearish on the longer-term outlook. And this is why.
The differential in the US/Australian interest rates
Our dollar has been a major benefactor of increased bond spreads between the US and Australia. Put simply, in recent years, international fund flows have moved into Australian bonds because they offered materially higher rates than US treasuries – providing support for our dollar in the process. But, following recent US interest rate rises, this differential has compressed significantly – for example, two-year Australian government bonds now offer less than half a per cent more than their US counterparts compared to 2011 when that same bond offered 3-4 per cent more when the AUD was well above parity. As this yield spread has compressed, the AUD has remained stubbornly high. But, we believe it will be forced lower over the medium term as a result. Future monetary tightening in the US is expected yet we believe medium-term rate rises are less likely in Australia, which will further compress the differential.
The medium-term outlook for our economy
While there’s been a lot of speculation that the RBA may raise rates, we believe there are limited—if any—opportunities for rises in the medium term. While Australia’s residential property market has underpinned our economy in recent years, there are several signs these forces are reversing; from more restrictive lending practices and increasing mortgage rates to likely over-supply in selected markets (notably Melbourne and Brisbane inner-city apartments). In addition, wage growth has now moved lower than inflation, resulting in negative real wage growth. And this, coupled with record levels of household debt, would make any meaningful rate increase extremely difficult without placing significant stress on mortgage repayments and creating greater downward pressure on our economy. Ironically, a stronger AUD provides greater economic headwinds and thus further diminishes the possibility of the RBA raising rates.
The status of our commodities
Our economy remains heavily reliant on the international export of our iron ore and coal, with the dollar heavily tied to this by proxy. While commodity prices have fallen from recent highs over the past month, over the longer term we maintain a relatively bearish outlook on iron ore due to the softening demand from China and expected excess supply coming on line, given the increasing adoption of renewables and increasing concerns regarding climate change.
For investors, the Dixon Advisory Investment Committee believes maintaining an unhedged exposure to the USD across a range of asset classes is an important consideration – despite the recent rally by our Aussie dollar. This strategy may mitigate against concerns about our economy given the range of potential headwinds. Further, the US dollar is still seen as the ultimate safety currency, and we would expect it to strengthen in times of market volatility. While the recent rally in the AUD has impacted returns of international investments to Australian investors, if you’re still thinking about adequately diversifying your portfolio outside of the Australian market, now may be just the time to consider it.
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.