The volatile Australian dollar ($A)

Currency issues are very salient in the Australian finance system, including wealth management.  Australia is, after all, a small open, resource based economy with a floating currency.  I am going to talk about the $A quite a lot in this newsletter over time.  To begin with I just want to look at the history of the $A to bring out the following points.  

Graph 1:  $A from 1 Jan 1970  to  30 Nov 2014

Newsletter 1 graph

1.  Mere opinion:   

What is the direction of the $A over the next month?  I don’t know – nobody knows.  Over the short term, measured in months, the best model of the path of the currency is a random walk.

When commentators or financial advisers speak as if they know what will happen to the $A they are only expressing opinions.  Pseudo experts have to express strong opinions, because they don’t have anything else.  And, expression of certainty is often mistaken for expert knowledge – ‘He must know what is going to happen, just listen to how certain he is.’  Don’t be fooled by that type of baloney and definitely don’t pay anyone for it.

2.  Volatility:     

Exchange rates are volatile.  You might think that since the $A has fallen 25 percent from its 30 year peak of $1.09, the next move is more likely to be up – it can’t fall much more.  That is not right.  I have already said that in the short to medium term the exchange rate is a random walk – it is not mean reverting.  A decline last month does not imply an increase up next month. 

Moreover, currencies are more volatile than most investors realise.  The $A tumbled from $1.10 to $0.60 from early 1982 to mid 1986 (see the blue line in the graph above).  From July 2008 to March 2009 it tumbled from $0.95 to $0.59.  Could the $A fall from its current $0.81 to $0.60?  Yes, it could.  What would cause that?  Lets come back to the factors that drive the $A next time.   

3.  The $US and the TWI:  

It is not obvious that we should focus on the $A v $US exchange rate.  The Trade Weighted Index (TWI) may be more relevant.  It shows the level of the $A against a basket of currencies, where the weight of each currency in the basket is the percentage of Australia’s total trade that is done in that currency.  See the red line above.

The TWI is a better measure of how much the spending power of Australian households changes when the $A moves up or down.  If you like to drive German cars and holiday in Italy and your pension fund owns more European shares than any other, then the Euro may be more important for you than any other currency.

You can see in the chart above that the TWI is less volatile than the $A/$US exchange rate.  The $A has fallen far less in TWI terms than $A terms over the last year.  In that sense the $A fall is less dramatic than it seems and will have less stimulatory effect on the economy than might be expected by just looking at the $A versus the $US.

4.  The $A plunge in 2008:

The $A plunged in the GFC, as the chart above shows.  It fell nearly 40% over just 3 months — from $0.98 on 22 July 2008 to $0.61 on 28 October 2008.  A year later it had almost fully recovered to $0.93.  The initial plunge was caused by unwinding of the carry trade.  I will discuss the carry trade another time.  But note for now that in a crisis the currency can plunge quickly but then regain its value in relatively quick time.

5.  Long term secular downward trend:    

The graph above shows that the overall trend of the $A against the $US is downwards in the long run (as measured in decades).  This is to be expected.  Interest rates in Australia have been higher than those in the US over many decades (the $A yield curve has been above the $US yield curve).  Because the time value of money is higher in Australia, the expected return on assets (of similar risk and illiquidity) is higher in Australia.  $A assets have higher expected returns than similar $US assets.

What offsets that difference in returns in the two countries in the long run is the slow, secular decline in the $A against the $US (secular here means continuous and not cyclical).  It is inevitable that this should be so.  Why would an investor hold a 2 year US Government Treasury note with a yield of 0.65% when they could hold an equally risk free Australian Government note with a yield of 2.2%, unless there was an expectation that the $A will fall against the $US.

Over time spans of months this effect is not noticeable, but over decades it is inevitable.  This concept is known as interest rate parity – the difference in interest rates between countries is compensated for by expected changes in exchange rates in the long run.   

We will keep talking about the $A in future newsletters.  There is a lot to say about:  how investors should adjust their portfolios as the $A changes;  whether investors should hedge against changes in the $A and how to do that;  how a fall in the $A stimulates the Australian economy; the factors that drive changes in the $A, what exchange rate movements mean for businesses, and many other topics.




Picture of Dr. Sam Wylie

Dr. Sam Wylie

Director, Windlestone Education
Principal Fellow, Melbourne Business School

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