ANZ FX: AUD suffers the perfect storm

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Authors:

Amy Auster

Head of Foreign Exchange and International Economics Research +61 3 9273 5417

[email protected] Tony Morriss

Senior Currency Strategist, Foreign Exchange and International Economics Research 61 2 9226 6757

[email protected] Amber Rabinov

Economist, Foreign Exchange and International Economics Research +61 3 9273 4853

[email protected] 05 September 2008

ANZ FX: AUD suffers the perfect

storm

Range of AUD/USD0.82 to AUD/USD0.88

anticipated in 2008, and moving lower in 2009

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For Economics & Markets Research to be the most respected, sought-after and commercially valued source of economics and markets research and information on Australia, New Zealand, the Pacific and Asia.

Economics & Markets Research

The run of the US dollar

• The incredible rise of the US dollar over the past six weeks has longer-term implications for the Australian dollar. We

are revising our currency forecasts to account for this major shift in the market, and have moved down our expectations for the AUD/USD exchange rate from a previous forecast of AUD/USD0.90 or above by December 2008, to AUD/USD0.86 for year-end. • There is more downside risk to this forecast than potential

upside. We are forecasting a year-end exchange rate that is

above the current trading range of AUD/USD0.81-0.84, because we believe current levels represent an unstable overshoot of fair value (which we currently estimate at AUD/USD0.89). As a result, we do expect some AUD recovery in the coming weeks. Nonetheless, the AUD has traded at a significant discount and/or premium to fair value before, so there is a possibility that the expected recovery does not occur.

• Most major currencies have experienced sharp depreciation against the USD in recent weeks, but for the AUD/USD to collapse by 17.5 US cents in just 8 weeks is the equivalent of a freak wave in its 25-year history. The fall in oil and gold

prices (off 21% and 17%, respectively) and downshift in local rates expectations has exacerbated the AUD’s fall. Although a retracement from the big sell-off seems probable, the AUD has blown through so many major support levels on the way down that seems more likely than not that the AUD will be capped below AUD/USD0.9000 in the coming months. Support is seen at AUD/USD0.80, but is more fragile given recent moves.

Figure 1: AUD/USD: An unprecedented move

0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 95 96 97 98 99 00 01 02 03 04 05 06 07 08 AUD/USD Source: ANZ

• The past several months have served as a reminder that although the AUD is the fourth most traded currency globally, it features higher volatility than the other majors. The AUD/USD rate over the course of a single year has gone up and/or down by AUD/USD0.1266 on average over the past 10 years (an 18.4% move versus the average level of the currency). In 2008 alone, the AUD/USD rate has traded in a 17.5 US cent range (19%) in contrast to 16.5 US cents (10.8%) for the EUR/USD, 27 US cents

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ANZ FX: AUD suffers the perfect storm - 05 September 2008

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The changing fortunes of the USD

• The rocketing USD has led many to ask whether we are at the start of a long-term rally for the US dollar. Our view is that the US dollar is starting to

recover, which it must in light of its recent extreme, historic low of 71.5 for

the USD trade-weighted index (TWI). The recovery should continue in

2009 and 2010, but the USD at this stage is not forecast to regain its previous highs. Put another way, the USD is starting a cyclical recovery, but

from a structural point of view may remain weaker against other currencies over the course of this next business cycle. Our forecast is for the TWI to peak at 90 in late 2010, representing EUR/USD1.20 and GBP/USD1.70. This is somewhat below the TWI’s long-term average of 101, and well below the 2002 peak of 120, or the 1985 peak of 160.

• The lack of faith in the USD is based upon the fundamental view that the US

economy is unlikely to rebound quickly from the pending consumption recession. On our forecasts, the Fed funds rate does not return to a “neutral”

setting of 4.5% until late 2010. Perhaps more importantly, we believe there

may be more diversification of financial flows away from the US –

caused by the attraction of rapidly developing markets elsewhere, and the reputational and regulatory damage exacted on US markets by the tech wreck, Enron collapse and credit crisis. The EUR is the first major competitor the

USD has ever seen as the Euro zone has potential to generate a high share

of the global financial stock, and is now a major trade partner for emerging market countries. It all adds up to a bigger role for the EUR as a benchmark currency in our globalised world.

Outlook for AUD

• Just as the USD is not expected to reach previous highs, we do not think the

AUD/USD will descend to the deep lows of previous cycles. Commodity

prices should support the AUD well above the 2001 trough of AUD/USD0.49; we have the AUD falling to AUD/USD0.70-74 in 2010 before rising again in 2011.

• Nonetheless, the recent big swings in the market argue for a fair degree of caution around any forecasts. The below chart shows results of

the Reuters forecast poll taken in August, and highlights how the median market forecast for AUD/USD over the next 3-6 months have moved down by 7-8 cents from the July poll. The 12-months ahead forecasts feature a very wide range.

Figure 2: AUD: Wide range for future expectations

0.6800 0.7200 0.7600 0.8000 0.8400 0.8800 0.9200 0.9600 1.0000 1.0400 1.0800 1.1200 Spot +1mth +3mth +6mth +12mth ANZ Forecast Market di Old median - July survey

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Risks to the forecast

• The extreme movements in the FX markets reflect great uncertainty over the global growth outlook. Bears are convinced that the credit crisis

has brought the global economy to the verge of a downturn not seen since the Great Depression. Bulls believe China will turn a G7 recession into a very soft global landing. ANZ’s view is in the middle of these extremes. We expect global growth to slow to trend, as growth in Asia softens while the US and EU falter. Oil prices are forecast to fall to US$95/bbl early next year and the Australian economy is forecast to slow down, but avoid recession.

• The AUD is at the pointy end of this debate. On the one hand, Australia is a fully developed economy that has been enjoying a robust boom in housing and personal credit – funded in part by foreign capital inflows that have dried up in the wake of the credit crisis. With funds now more expensive, Australian households that increased their debt exposure over the past several years are cutting back. In this, Australia is experiencing some elements of the

US-UK credit crunch. On the other hand, Australia is unique among OECD

countries as a significant exporter of hard commodities Moreover, China is a major export market for these commodities, and demand in China remains robust. The massive terms of trade boom that Australia continues to

experience provides a cushion from tighter credit conditions, in the

form of persistently higher gross domestic income.

• The two key variables that drive the Australian dollar – commodity prices and interest rates – are being pushed and pulled, and their path over the next six months determines the outcome for AUD.

Road map – turns to watch for in the period ahead

• The key factors to watch in terms of the AUD outlook are as follows:

• Oil prices. Oil prices are important for two reasons. First, the price of oil is a

benchmark for global commodity prices. The price of oil over the past few years has had a big impact on the price of gold, which in turn goes through periods of very high correlation with the AUD. Second, oil prices tend to have an inverse relationship with the US dollar – when oil prices rise, the US dollar falls and vice-versa. If oil prices surge above US$120/bbl again for WTI in the coming months, this is a very bullish signal for the AUD and would suggest the AUD/USD could surge past 0.90. However, if oil prices continue to plummet past US$100/bbl down toward US$80/bbl, the fall past AUD/USD0.80 could be closer at hand than our forecasts suggest.

• The US dollar. Even if oil prices remain around present levels in the coming

months, the USD could see additional movement due to economic or political events in the United States. Feasible scenarios that could cause the US dollar to give up its recent strength include: renewed equity market weakness; further problems in the financial system; and another leg down in US economic growth that would prompt the Federal Reserve to cut interest rates further. Since the USD is priced relative to other currencies’ prospects, a better-than-expected economic outturn in the EU could cause the EUR to strengthen at the expense of the USD, and thereby support the AUD. On the other hand, if US economic data continues to surprise on the upside and the US avoids a recession, this is USD-positive and AUD-negative relative to our forecasts. The EUR is the main variable to watch here. A lift past EUR/USD1.49 would be a negative signal for the USD, whereas a descent below EUR/USD1.40 would imply a more rapid USD recovery than we are currently anticipating.

• Domestic interest rates. This is the superhighway for the AUD – the road that

really matters. The importance of the RBA’s shift from a hawkish stance on interest rates in July to cutting the cash rate in September in terms of the AUD’s recent performance cannot be overstated. At present, the futures markets implies expectations of a further 75 bps cuts to the RBA cash rate in the coming 6 months. ANZ’s forecast is for a more gradual reduction, with the RBA forecast to cut rates in November and then remain on hold until May. Should economic data or external circumstances cause the interest rates markets to change its expectations on the path of future interest rates significantly in either direction, the impact on the AUD would be substantial. Watch this space, and the data.

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Exchange Rate Forecasts

Current Sep-08 Dec-08 Mar-09 Jun-09 Dec-09

Australia and New Zealand FX Crosses

AUD/USD 0.8161 0.85 0.86 0.83 0.80 0.76 NZD/USD 0.6653 0.67 0.65 0.68 0.65 0.61 AUD/JPY 87.10 91.80 92.88 91.30 88.00 86.64 AUD/EUR 0.5720 0.59 0.60 0.59 0.59 0.58 AUD/GBP 0.4639 0.47 0.48 0.47 0.45 0.44 AUD/NZD 1.227 1.27 1.32 1.22 1.23 1.25 AUD/CAD 0.8732 0.90 0.93 0.91 0.90 0.87 AUD/CHF 0.9073 0.93 0.94 0.91 0.91 0.92 AUD/CNY 5.579 5.78 5.81 5.58 5.36 5.05 ATWI 64.90 67.13 68.30 66.42 64.38 61.85 International FX Crosses USD/JPY 106.7 108 108 110 110 114 EUR/USD 1.427 1.45 1.44 1.40 1.36 1.30 EUR/JPY 152.3 157 156 154 150 148 GBP/USD 1.759 1.80 1.78 1.77 1.76 1.73 EUR/GBP 0.8111 0.81 0.81 0.79 0.77 0.75 USD/CAD 1.070 1.06 1.08 1.10 1.12 1.15 USD/CHF 1.112 1.09 1.09 1.10 1.14 1.21 DXY 78.79 78.0 78.7 80.5 82.2 85.6 Asian FX Rates USD/CNY 6.837 6.80 6.75 6.73 6.70 6.65 USD/HKD 7.807 7.80 7.80 7.80 7.80 7.80 USD/IDR 9357 9250 9075 9100 9175 9125 USD/INR 44.36 43.75 44.50 45.00 44.50 43.50 USD/KRW 1142.1 1050 1090 1095 1100 1090 USD/MYR 3.4575 3.39 3.42 3.43 3.44 3.40 USD/PHP 46.825 45.50 46.40 47.10 46.40 44.50 USD/SGD 1.440 1.43 1.45 1.48 1.46 1.42 USD/THB 34.59 34.35 35.00 35.10 35.20 34.00 USD/TWD 31.88 31.75 32.25 33.00 32.50 31.50 USD/VND 16585 16500 16400 16300 16070 16130 Pacific FX Rates PGK/USD 0.394 0.40 0.43 0.41 0.39 0.35 FJD/USD 0.618 0.62 0.62 0.62 0.60 0.58 WST/USD 0.3734 0.39 0.39 0.38 0.38 0.36

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