Forex Investment and Currency Trading

US dollar weakness

The single most important contributor to AUD strength will be a weaker US economy than is currently priced by the currency and interest rate markets. It is forecasted the ongoing weakness in the US economy as house prices continue to fall; employment contracts sharply; gas and food prices remain high and consumer spending and investment soften further. Wage pressures and core inflation are easing and the Fed will have adequate scope to ease further through 2008 and 2009. The shock that the Fed is easing further and the ongoing weakness in the US economy will cause the USD to resume its downward drift.

Since its peak in February 2002, the US dollar index has depreciated by 11.5% to March 2004; stabilised while the Fed was tightening between June 2004 and June 2006 with a fall of ‘only’ 4%; and resumed its downward adjustment when the Fed stopped tightening in August 2006. It has fallen another 12% to date. A further decline of 5% over the next year against a recessionary backdrop seems eminently reasonable.

Widening yield differential

The RBA will hold rates steady over the next year. Domestic demand growth will slow from 6% in 2007 to 3% in 2008 but inflation will remain near 4% through to year’s end. Any expectation of rate cuts by the RBA in the first half of 2009 will fade as we get closer to the time.

High fair value

This time last year, the AUD was trading at 82¢ compared to an estimated fair value of 95¢. Two years ago fair value was 83¢ compared to spot of 77¢. In each instance, spot closed the gap to fair value in the ensuing twelve months, only to find fair value higher again when it got there.

Commodity prices and real TWI

There has been a reliable relationship between Australia’s real effective exchange rate and the terms of trade. That relationship has broken down somewhat due to the recent surge in the latter, which is estimated will rise by 23% in 2008. This will add 2% – 3% to national income growth. That is by far the strongest terms of trade performance over any year in this upcycle. That outlook includes an expected easing in base metal prices but this looks a mere trifle next to the extraordinary boost to coal prices (150% plus) and iron ore (70% plus). It is reasonable to expect some lagged positive response to this promised stimulus. So far the AUD has probably gained only about 2¢ on this staggeringly positive
story.

Credit crisis eases

Australia is a debtor nation in both a flow and a stock sense, with a current account deficit of 7% of GDP and net foreign debt around 55% of GDP: a major vulnerability. The concern has been that a potential global capital strike that punished all borrowers indiscriminately (recall last August) was a real possibility with major banks deleveraging en masse. Credit spreads and anecdotal evidence indicates that the risks to Australia of a ‘capital strike’ and the associated inability of the banking
system to finance the foreign debt have largely passed.

Current account improvement

Net exports is expected to begin contributing to growth in the second quarter. Over the four quarters, net exports have reduced GDP growth by 2.1ppts. Over the next four quarters net exports are expected to add 1.5ppts. The dynamics will be dominated by rising supply as sustained capacity investment in the resources sector pays dividends and weather conditions boost farm sector output.

Not really a big call

In conclusion, it seems a huge stretch to call parity with the US dollar. However the reality is that we are almost there. In the context of regular volatility in the AUD, a 6.5% move from current levels would be quite unremarkable. For the last five years the currency has averaged a 12% gain.