Why The Australian Dollar Is Likely To Have Seen A Short-Term Base

The extraordinary performance of the Australian dollar over 2006 through early 2008 was created by a number of factors, not least of which was the commodity price boom and explosion in carry trade positions.

Both of these categories were underpinned by the low cost of capital that funded speculative purchases and the increasing number of hedge funds looking to rotate investor's money.  The AUD rallied to historical highs of 0.9849 this year as the conflagration of these factors boosted the currency only to reverse sharply as markets imploded in response to the global credit crunch. The AUD retreated to lows of 0.6025, as speculative holders of AUD were squeezed out of the market. Despite the sharp fall, and prognostications of more AUD weakness towards 0.5000, current levels of the AUD are now an attractive buy particularly with the Australian economy still set to benefit from the residual effect of higher commodity prices. The emergence of the Reserve Bank of Australia to support the Australian dollar in late October is only one indication that the AUD will find a base, with the RBA typically right over the longer term, and currently locking in profits from their prior intervention to stem Australian dollar gains.

In the last few years, many investors who targeted commodities, would buy the Australian dollar as part of a portfolio that included commodity positions funded with borrowed low interest rate currencies such as the Japanese yen. In addition, the same funds as well as Japanese retail investors would purchase for investment the higher yielding currencies such as the Australian dollar, New Zealand dollar, South African Rand and Turkish Lira. Certainly the performance of the Australian economy was a supportive factor, with the economy bolstered by global growth and rising commodity prices.  The broader trend towards global portfolio diversification also supported AUD with central banks were among those participating in the portfolio diversification, buying currencies such as the euro and sterling and with Asian central banks showing strong demand for the AUD. The Asian central banks weighted their currency reserves towards their trading partners, thus supporting AUD. Another support for the AUD was corporate merger and acquisition flows with foreign investors, particularly from China, buying Australian resource companies as commodity prices rose. This resulted in a surge in capital inflows. However, speculative demand and commodity driven interest has reversed and mergers and acquisitions have seen a precipitous drop.

Speculative net longs reported by the CFTC in CME contracts actually peaked  in December 2006 with speculators turning short in September 2008 for the first time since June 2004. Speculative AUD-JPY carry trade positions held by Tokyo Financial Exchange, among the largest retail foreign exchange providers in Japan, hit record highs of 107K in contracts on August 29th, and has since declined to 42.9K and the lowest levels since June 2008. These two data sets suggest that many of the speculative plays in AUD have been squeezed out and may now alleviate some of the heavy selling pressure seen in the last few months.

The Australian dollar has had a positive correlation between commodity indices given Australia's position as a net commodity exporter. Indexes such as the Reuters-Jefferies Commodity Research Bureau (RJ-CRB) and the S&P Goldman Sachs Commodity Index collapsed as funds exited their commodity investments and as global growth expectations fell, which drove commodity prices lower. This slide in the indices also impacted the AUD. The RJ-CRB hit a four-year low in October, while the Baltic Dry Index, a shipping index that reflects global demand for transportation of goods, (mostly commodities) hit a six year low. Base metal prices such as zinc, nickel and copper have hit multi-year lows and some mines, such as the zinc mines closed by OZ Minerals and Ausmelt and Xstrata closing nickel and zinc mines as well. Other mines are to be mothballed as the cost of production now exceeds revenue obtained for current zinc and other metal prices. However, the retreat in commodity prices has now erased the premium for resources and metals fuelled by the "bubble" created by commodity demand, and prices are likely to stabilize near levels seen for commodities around 2004-2005. Stabilization in these metals will help provide a base for the AUD As well.

Overall, the catalyst for the AUD performance has been based on expectations that the rising metals prices would drive export performance, which in turn pushed  Australian interest rates higher (attracting the carry trade) and  underpinning the AUD. And despite the slide in metal prices and recent drop in interest rates, in relative terms to the global economy, the outlook for the Australian economy and the AUD is not bad. The AUD has fallen almost 40% from its peak as commodity prices declined. This will mitigate the impact of the decline in commodities in dollar-denominated export receipts for Australian companies. In addition, many Australian companies prior to the commodity crash had already negotiated higher priced terms for commodities such as iron ore and coking coal that are just beginning to be reflected in recent Australian trade data. Though the credit crunch and global slowdown has seen end users now clamoring to renegotiate lower prices the overall higher demand levels in large emerging nations such as India and China are still seen supporting raw material exports, despite the fall in prices.

AUD is now trading well below value levels that held steadily around 0.7000-0.8000 through 2004 to 2006 and it is reasonable prognosis that AUD could return to that level which makes current levels near 0.6000 an attractive buying proposition. Slowing Australian economic conditions will dampen imports with housing seen falling and consumer spending declining and may help improve the trade position. Exports, as indicated by recent data, may slow, but newly increased mining production and the recently negotiated higher prices will underpin export receipts over the coming months. The fall in the Australian dollar will also underpin receipts as dollar-based commodity prices are converted into AUD, thus offsetting some of the price decline in spot commodity prices. It is yet to be determined however how much resource demand will fall with Japanese, Indian and China steel companies cutting production and with it, demand for iron ore, one of Australia's largest export earners. The Australian Bureau of Agricultural and Resource Economics (ABARE) has forecast that iron ore exports for the 2008-2009 fiscal year would top $A39 bln, but the fall in steel production is seen dampening iron ore demand. Australian's Atlas and Mt. Gibson and Brazil's Vale has already reported that China's demand for iron ore has dropped significantly. Spot iron ore prices delivered to China have already dropped over half from $US200 a ton to $US80-$US90 a ton, falling to  19-month low in October. Spot steel prices themselves have seen a fall from $US1200 a tonne in July to $US252 a tonne. Similarly, the steel industry drives the demand for coking coal which is expected to eclipse iron ore demand, with ABARE forecasting $44 bln in earnings next year. Some demand for coking coal appears to be more inelastic with demand still seen steady and many companies, such as Tata Steel having just negotiated higher prices in the last few months but overall, prices are seen softening as well. A number of institutions including Goldman Sachs JBWere and Merrill Lynch have already cut their forecasts for both iron ore and coking coal for the coming year. However, ABARE's forecasts were based on AUD at 0.8500 and with AUD levels nearing 0.60 as of October 27, the 30% gain in currency advantage for exporters due to the lower AUD will offset some of the deterioration in commodity prices. The forecast from ABARE for Australian exports for 2008-2009 were expected to increase to a record $A214 bln, increasing by $A65 bln so even a softening of demand, offset by the advantage of the lower AUD, will still provide a cushion of support for the Australian trade picture.

The bottom line is that the fall in commodities may not hit Australian export receipts immediately, and the lower currency is likely to maintain Australia's terms of trade position in the near term, providing a base for the Australian dollar on exporter demand. Other potential risks remain for the AUD however including forecasts of deeper RBA rate cuts through 2009 with some forecasters even calling for cash rates to fall to 5% or below. Any pressure that would weigh on AUD will be offset by concurrent fall in global rates in other nations ease rates as well. The Australian housing market remains vulnerable. Even before the U.S. subprime debacle became a focus, the housing bubble in Australia garnered attention from analysts around the globe. More recent warnings highlight that house prices are running at seven times income levels when three times income is affordable for home buyers. (Even U.S. house prices are at just 3.5 times median income levels.)  Between June 2002 and June 2008, median home prices in major Australian cities doubled. Some see housing falling 10% and some are forecasting a fall as deep as 50% with the slowdown in commodities and expectations of rising employment two factors expected to put pressure on housing. Mergers and acquisition flows that supported the AUD through the first part of 2008 will dissipate along with the fall in commodities, making mining and resource assets less attractive, and the lack of available credit will hamper acquisitions. AUD is now closer to the lower edge of the historical trading range and Australian banks and the economy are expected to weather the economic conditions better than the U.S. or Europe. On a valuation basis, the Australian dollar at current levels is attractive to both investors and traders, targeting gains toward the prior consolidation range around 0.7000-0.8000 into early 2009.

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