Speculations on the Currency

I’ve spent the last few months working in the principal investment area of a bank with typically harsh restrictions on social media and comment of all sorts, and as such have been unable to post. With that episode now over (and I’ll comment on the experience when the dust has settled), it’s time to wade in to the national pastime of speculating on the aussie dollar (forgive any repetition from previous posts).

For all the doom and gloom surrounding the humble aussie, and considering it basically halved in 2008, then doubled again, it has been remarkably stable. Over the last three years, every time things have gotten a little shaky, it has traded as traded things should trade: plunging sharply, causing a price driven market reaction, and getting pushed back to – dare I say – equilibrium.

Yet everyone seems to think the aussie dollar has somewhat peaked and is heading downhill. The argument seems strong: the comprehensively heralded coming collapse of the iron ore price will reduce the multi billion dollar bids of AUD.

This misses the point. The reason ore prices are heading downhill is due to increased supply – the demand growth side is quite strong. Fortunately, as a command economy, China actually tells you what it’s going to do, five years in advance, and the urbanisation story is by no means complete.

So as dirt cheap Australian ore comes online, while there will almost certainly be a price reaction southward, what matters s the total flow of cash, and the lower price will be counteracted by the increase in total export. Where the balance ends up is anyone’s guess and unmodelable.

There’s another part of the picture. Australia has a major export that has barely got of the ground: natural gas. Australia is not exactly a low cost producer, but tens of billions have already been sunk into these projects. As with all mining and high capital investment, once the initial expenditure has been made to build the mine, gas plant, liquification terminal or ship, the economics are hugely in favour of continued production, even if it ensures the project makes a loss. Better to recoup at least part of a failed investment rather than write the whole thing off.

Time and again analysts are caught completely off guard and have to hastily and humbly restate their forecasts when their object of expertise falls straight through its arbitrarily declared ‘price floor’. I think I’ve harped on about htis before.

And no matter how low aussie interest rates seem from a seat in Sydney, or how much chest-beating there is from armchair economists, they are still substantially above the rest of the developed world, even compared to our Northern Hemisphere economic equivalent, Canada. The carry trade is still on – from a yield perspective it makes sense to hold AUD.

So, as although the iron ore price will almost certainly fall to the industry’s pressure point, it will be balanced by the huge increase in total ore exports will easily accomodate it. The stability of the AUD is likely to continue. In fact, once you take natural gas into account, there is actually a feasible case for a higher aussie dollar.

And finally, there’s a mathematical quirk that increases stability in the AUDUSD, as well as pairs like EURUSD that almost noone ever seems to consider. The giants in the room – central banks with huge foreign currency holdings – determine their weightings as percentages. To keep it simple, if an Asian bank holds half its currency in EUR, and half in USD, as one falls relative to the other, it buys the falling one. In enormous size. This rarely considered stabilising impact can barely be overstated. As foreign central banks have diversified into the AUD (as they should), this natural steadier comes into play.

To put it another way, if a central bank has set percentage holdings (as they generally do), when there’s a sharp shift in a currency movement,) you can guarantee there will be a market-moving order in the opposite direction. Typically hedge funds have been the losers on the other side of the trade – think of the fortunes lost in bets against the Euro every time the continent flares up.

Unfortunately neither being long or short the aussie is a particularly interesting trade right now. If you want to bet against the recovery (we are, after all, about five years into it) or perhaps more rightly, commodity deflation, then there are other places to look.