Australia’s Central Bank Must Go It Alone

By Ari Charney • November 15, 2013 • Pacific Digest

Australia may be on the other side of the globe, but the US Federal Reserve’s dithering over monetary policy since early May has had an outsize influence on the country’s exchange rate. While US investors enjoyed having their gains in Australian equities enhanced by a relatively strong Australian dollar, now that the resource boom has peaked, it’s imperative that the currency weaken in order to boost the competitiveness of the country’s exports.

The Aussie had been trading above parity with the US dollar for much of 2011 and 2012, and finally fell below this key threshold in early May, as Federal Reserve Chairman Ben Bernanke indicated that the central bank was thinking seriously about how to curtail its extraordinary stimulus, otherwise known as quantitative easing. As the market prepared for a September taper, which, of course, never came to pass, the Aussie fell as low as USD0.89 in late August.

With just a couple press conferences, Bernanke had inadvertently engineered a decline in the Aussie that the Reserve Bank of Australia (RBA) failed to achieve on its own, despite seven rounds of interest rate cuts. The RBA has since cut rates again, in August, bringing its short-term cash rate to 2.5 percent, an all-time low.

Nevertheless, movement in the Aussie as of late continues to be largely correlated with traders’ shifting expectations regarding the Fed’s monetary policy (and to a lesser extent the strength of the Chinese economy). President Barack Obama’s nomination of Janet Yellen to succeed Bernanke as head of the central bank may have even extended the timetable for when the Fed starts to wind down its $85 billion per month bond-purchasing program.

As Bernanke’s key deputy at the Fed, Yellen is known to share his dovish stance toward monetary policy. In appearing before the US Senate’s Banking Committee on Thursday, she said there was no set time for a taper, though it obviously can’t continue indefinitely. She acknowledged that the market’s swift reaction to Bernanke’s comments in the late spring had forced the Fed to defer its taper, but also said the Fed shouldn’t be a prisoner of the market. If confirmed, Yellen can be expected to mirror Bernanke’s approach to policymaking, even if their personal style differs.

That means the Aussie likely has a base of support at current levels, which earlier this month the RBA characterized as “uncomfortably high.” The currency recently traded near USD0.937, down about 11.6 percent from its year-to-date high in January, but up 5.3 percent since August. According to a Bloomberg survey of economists, the Aussie is expected to trade at USD0.89 next year, while bottoming around USD0.87 in 2016-17.

The RBA says there’s a chance the exchange rate could remain near current levels over the next couple years, though a softening resource sector could lead to declining capital inflows, which would help depreciate the currency. But it notes that the currency is largely beholden to the monetary policies of the central banks of the world’s larger economies. That means the RBA will have to continue cutting rates to undermine the currency, since it won’t be getting any outside help from its central bank peers.

Though our gains are no longer being enhanced by the currency effect, a weakening Aussie should help our companies compete in the global markets. And we expect that performance to ultimately flow through to higher share prices for our recommendations, which should more than offset the modest decline in the currency.

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