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The Dollar in 2016 - Big Sky Financial Solutions

The Dollar in 2016



Forecasting the comparative value of the Australian dollar is fraught with difficulty and never so much as now when there are conflicting forces pushing the A$ in different directions.

The recent strength of the A$ has been driven largely by a weaker US$, rising commodity prices and Australia’s relatively high interest rates. The current weakness in the US$ stems mainly from the US Federal Reserve’s quantitative easing program and lack of urgency to raise interest rates at a time when other central banks, including the European Central bank, are beginning to raise their interest rates. Further contributing to US$ weakness is greater consumer confidence globally, especially in Asia, which has reduced demand for the US$ as a safe haven currency.

The industrialisation of China and other emerging markets has been a key driver of higher commodity prices in recent years. Australia as a net exporter of commodities has benefitted greatly from this by way of a rise in our terms of trade. At the same time, our higher interest rates compared to those in the US and Europe has made Australia an increasingly attractive place to invest, providing further support for the A$.

The asset consultant Russell Investments recently surveyed 40 Australian fund managers for their views and asked what they believed the value of the A$ would be against the US$ in five years’ time. The majority of fund managers believed the A$ would fall from its current level of around US$1.09 to between US$0.80 and US$0.90 cents. Not a single manager expected the currency to be trading above US$1.10 by mid 2016.

The Russell Investments survey shows that fund managers view the A$ at current levels as unsustainable over the medium term. The question is what will be the catalyst for a lower A$ over the next five years? Perhaps the biggest factor is a potential slowdown in China, where officials continue to try and strike a balance between strong economic growth and rising inflation. A slowdown in Chinese growth would impact our terms of trade and put pressure on the A$. Other factors include increased risk aversion triggered by Europe’s continuing sovereign debt woes, and a delay by the RBA in raising interest rates due to weakness in the non-mining sector of our economy.

What is particularly interesting in the Russell Investments survey is the range of views – anywhere from US$0.80 up to US$1.10. This wide dispersion highlights the risk of making big bets on a single exchange rate prediction. We prefer not to play the forecasting game and instead prefer to adopt a partial currency hedging strategy. A consistent 50% hedge effectively reduces volatility in portfolios, at lower cost, and, on average (when compared to more active approaches) adds value.

On a lighter note, the Economist’s Big Mac Index, an always amusing guide to whether currencies are at their “correct” level, indicates the A$ is overvalued by 22%, or by 12% after adjusting for GDP per person. (The Index is based on the theory of purchasing-power parity, the notion that in the long run, exchange rates should move towards the rate that would equalise the prices of identical goods and services around the world. The Big Mac is identical anywhere in the world and, all else being equal, should cost the same worldwide. In fact, a Big Mac costs US$4.94 in Australia vs. US$4.07 in the USA). Some fund managers would seem to broadly agree with the Big Mac Index, others are more bearish. We will have to wait and see who the better forecaster is. In the meantime, it seems now is the time to take your overseas holidays.

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