Is It Time to Dump the Australian Dollar?

In December, the Reserve Bank of Australia (RBA) has kept interest rates unchanged at a record minimum of two percent, sending an optimistic message to the markets. It was good news for equity investors, but bad news for those with a bullish Australian dollar forecast in 2016. The announcement sent the AUD/USD exchange rate plunging back to multiyear lows.

The message is that the economy has room to improve beyond the mining sector, yet the low inflation rate may tempt the RBA to follow the European Central bank (ECB), further lowering interest rates. The next RBA interest rate announcement is expected in February 2016 and the prospects for a further devaluation of the Australian dollar exchange rate is likely because of the continued bearish market for commodities and China’s slower growth.

AUD/USD Exchange Rate Forecast 2016

The AUD/USD exchange rate has experienced a rollercoaster ride. At the end of October, the Aussie dollar’s value was backed by favorable economic data published by the Reserve Bank of Australia, which sustained the AUD to USD exchange rate. Since late October, the AUD/USD outlook has improved since the latest dip in September, reaching 0.73 against the U.S. dollar on December 2, its highest level since October 15. (Source: “Australian Dollar Strengthens on GDP Growth,” Global Finance, December 2, 2015.)

In early December, the AUD/USD exchange rate gained 0.49% and appears to have safely left the September low point, when one U.S. dollar cost AUD$1.44. To understand the implications, at the start of 2015, one U.S. dollar cost a much lower AUD$1.19. In October, signs suggested that the central bank’s governor, Glenn Stevens, was in no hurry to cut rates, but the disappointing economic data could change that outlook in the future.




Chart courtesy of www.StockCharts.com

The RBA kept rates unchanged to the minimum value record of two percent, changing its message to the markets. Indeed, the central bank was finally able to see beyond the mining sector, where it noted some economic improvements. Meanwhile, the advantage to the Aussie dollar and to investors is that inflation remains low, leaving little room left for additional interest rate cuts.

This means that regardless of economic performance, the Aussie should, at worse, trade within a narrower band in comparison to the U.S. dollar; at best, it could gain, making the Aussie a currency to consider, at least until the RBA’s next meeting in February 2016.

Australia stands out in the world for its major commodities resources, including oil and iron, but especially coal. Coal is not just an energy source; it is a metallurgical mineral used primarily in the production of steel, while thermal coal is essential to generating electricity. Imports of thermal coal by Japan are still very significant.

The RBA has stated, in a note, that the value of its currency has been adjusted to the significant decline in the prices of the economy’s main commodities. (Source: “Lower Bulk Commodity Prices and Their Effect on Economic Activity,” Reserve Bank of Australia, September 2015.) After the decision, the Australian dollar swung back to a trading range of 0.7274. In the third quarter, Australian investments recorded a heavy collapse, reducing overall growth expectations, undermining recent optimism over Australia’s economic outlook, and causing a sharp depreciation in the Australian dollar’s value.

In fact, companies have reduced their investments in an even more concerted way than economists had feared, which, after all, should come as no surprise. Indeed, Australia’s economy has just witnessed its fifth consecutive quarterly decline. The investment data for the third quarter have affected the value of the AUD dollar. As a result, markets have hovered between the options of a rate cut in the paradoxical context of low inflation and already low rates.

Low Commodity Prices Could Crimp AUD/USD

China’s slowing economy has caused coal and iron ore prices to fall from their peaks, reaching unprecedented lows and deeply affecting the Australian economy. As bad as the situation has gotten, further demand reductions cannot be excluded. The AUD/USD exchange rate forecast for 2016 has led many mining companies to cut costs and improve efficiency, including in the black list, a reduction in wages and jobs and the imposition of an obstacle for investments.

Few companies are optimistic, while those most vulnerable have already declared bankruptcy, which has made government intervention, even from a conservative government, necessary. The government’s expansion policies have predictably devaluated the Australian to U.S. dollar exchange rate, producing adverse effects.

Ironically, gold companies have taken advantage of the negative AUD/USD forecast for 2016, because while supply and demand affects interest in industrial metals, this is not always true for gold. Indeed, the U.S.-based Newmont Mining Company, which has a large gold mine in Western Australia, has decided to expand, taking advantage of market conditions. (Source: “$120 million expansion for Tanami Desert gold mine,” ABC Rural, November 4, 2015). Many companies have also benefited from lower prices for oil and gas, not to mention that the country has become a very attractive destination for tourists or the young, eager to explore the world and/or study abroad.

Australia is learning to adapt to the low value of the Australian dollar and the very low level of official interest rates, recognizing that the resources boom has ended. The RBA has adjusted its focus, seeing a rather rosy picture of a strengthened labor market. This could see it get used to the new “model” and find a way to cut interest rates further in the same way that the European Central Bank has done to act as a stimulus.

Economic forecasts by Deloitte Access Economics have indicated the economic slowdown in China as the major obstacle to global growth, stating that this will continue to affect the Australian growth at least for the next two years. (Source: “Australian growth to remain below trend into 2017: Deloitte,” ABC, October 18, 2015.) The low interest rates and the Australian dollar being down help ease the impact, but the report suggests that it might take a long time before its sees a return to a positive balance. This, too, supports the ECB’s low-interest-rate model for the AUD/USD exchange rate outlook for 2016.

According to Chris Richardson, partner at Deloitte Access Economics, China is the largest contributor to global growth and it does not appear to have found quick-fix solutions to its internal problems. (Source: Ibid.) This means that government spending will reach or exceed levels normally seen during periods of recession, which will not help the Aussie against the U.S. dollar, especially considering that the American greenback will likely become more valuable as U.S. Federal Reserve Chairwoman Janet Yellen hinted that U.S. interest rates would be going up.

Blame China for Weak Australian Dollar

China’s economy has suffered in the third quarter of 2015, reporting a 6.9% growth rate. One of the lowest in recent decades, considering that at the height of the 2008–2009 financial crisis, it was 6.2%. China’s slowdown, given its role as a primary importer of Australian commodities, has hurt Australia’s mining industry, suffering under the weight of oversupply and lower prices for its resources.

In the past, China consumed vast amounts of resources, driving the prices of coal, iron, and oil. Nowadays, however, the steel industry, which absorbs the vast majority of the raw materials that China imports from Australia, is being dragged into confronting the phenomenon of oversupply.

China’s steel industry accounts for some 50% of world production and the demand prospects for related raw materials from Australia are pessimistic. Some EU countries have already alleged that China is dumping steel in international markets with prices even lower than those previously adopted by the same Chinese steel mills. (Source: “British steel has been left weak by cheap Chinese competition,” The Guardian, October 20, 2015.) Against this scenario, the Australian dollar only has room to drop further against the U.S. dollar.

Therefore, not only will Australia leave interest rates low, but it will also likely go for more cuts, as the market has few bullish prospects, given the continued raw materials crisis. Aussie dollar bulls might argue that the governor of the Reserve Bank of Australia, Glenn Stevens, announced he would keep the rate unchanged at two percent during the last review to date on December 2.

In 2015, the RBA cut rates twice, in February and May. However, in an overly optimistic sentiment, Stevens signaled its intention to raise them further last October. This has appreciated the Australian dollar against its U.S. counterpart. Still, traders estimated the chances of a rate cut in December at 40%. Given the limited chances of commodity prices going up anytime soon, the traders’ bearish prospects on the Aussie have an even greater chance of materializing.

It’s true that, overall, Australia has managed the commodities storm better than many commodity-focused economies, even as raw materials prices have dropped to their lowest levels since 2002. However, business investments have dropped 23%. While such indicators as gross domestic product (GDP) still saw two-percent growth, in the second quarter, unemployment was at 6.2%.

Australian dollar investors should note that over the past six out of seven years, the country has grown less than its own average, prompting the IMF to revise the country’s growth potential from 3.25% the previous year to 2.5%. Sooner rather than later, the RAB will be encouraged to manage that bearish forecast.

Property Bubble Could Hit AUD/USD Exchange Rate

Doubtless, Australian interest rates are at historic lows. All indications suggest they have not yet reached the bottom; the one brake on just how far they might go comes from the real estate sector. Indeed, the ultra-accommodative monetary policy has stimulated the real estate sector, where the RBA noted a sustained increase of property prices in the most populous cities of Sydney and Melbourne. (Source: “Rate cut to help housing, boost property prices,” The Sidney Morning Herald, February 4, 2015.)

Nevertheless, the phenomenon appears concentrated in those areas and the industry is well regulated; therefore, it is expected to avoid inflating to a bubble or worse—having the bubble burst. This would also support more rate cuts. The other factor supporting further rate cuts, and therefore the continued devaluation of the Australian dollar, is that overall, the policy underlying it has worked. The weakening Australian dollar appears, for now, to have allowed Australia to dodge the consequences of the commodity value crisis. The Aussie lost nine percent in the third quarter, the biggest drop for any of the advanced economies’ currencies, while losses amounted to 25% on an annual basis, as well as commodity prices.

As a result, even as Australia earned fewer U.S. dollars (commodities are traded in U.S. dollars), the low value of the Aussie has caused the related local revenue to increase, offsetting the lower prices of those same resources. However, the specter of further drops in commodity export volume to China, in particular, may no longer support the exchange rate mechanism that has worked until now, prompting the need for economic stimulus and lower interest rates.

The Bottom Line on the Australian Dollar in 2016

The one bullish factor, though much less influential than mining, supporting the value of the AUD/USD exchange rate, came from higher prices for dairy products, since Australia is the main exporter in the Asia-Pacific region. (Source: “Can Australia meet Asia’s growing dairy demand?” BlueNotes, November 4, 2015.)

Milk prices rallied in the fall, such that New Zealand, highly dependent on the dairy industry, saw some relief after a collapse in prices early in 2015, which has forced exporters of milk to cut their payments to farmers, eroding their income for the current season and weighing on the rural sector’s outlook. However, as strong as the dairy industry might be, it cannot sustain the Australian economy by itself and the RBA will have to cut rates again in 2016 as stimulus, lowering the value of the Aussie dollar.

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