It's China, Not U.S. Treasuries, That Will Decide Aussie's Fate

(Bloomberg) -- The Australian dollar’s strength despite Treasury yields eclipsing those on local government debt for the first time since 2001 has perplexed some observers. It shouldn’t, says Macquarie Bank Ltd.

“The key difference between now and 2000-01 is that the prices of Australia’s resources exports are around 180 percent higher and the terms of trade are up nearly 60 percent,” said Justin Fabo, senior economist for Australia at Macquarie. “Modeling of the fundamental value of the Australian dollar shows that the terms of trade is by far the most important determinant.”

The Aussie bought less than 50 U.S. cents when U.S. government bond yields were last higher than their Australian equivalents. That compares with its current level of just under 80 cents, prompting speculation in some quarters that the local dollar could come under pressure.

Australia’s bond yield has been higher than Treasuries since the turn of the century, as a mining investment boom saw its economy outperform global peers. Central bank interest-rate increases sent the currency soaring to a peak of $1.10 in 2011, while rates in much of the rest of the world were near zero or negative.

But as a healing U.S. economy pushes the Federal Reserve to tighten, and Australia remains stuck with record-low rates and tries to jump-start inflation, the advantage Down Under appears to be at an end.

“Interest rate spreads are significant but play a much smaller role as a fundamental driver of the Australian dollar, nor do they have a consistent correlation with short-term moves in the currency,” Fabo said. “As a case in point, Australian-U.S. spreads also narrowed substantially in 2004-06 but the Aussie remained in the 70-80 cent range.”

So as always with Australia, it comes down to Chinese demand. The consensus is the world’s second-largest economy will slow amid its transition to consumption-driven growth, lowering commodity prices. At the same time, a synchronized upswing in global growth -- underpinned by industrial production -- could offer support for resources.

As a result, Macquarie is running two scenarios: a 20 percent drop in Australia’s terms of trade, or export prices compared with import prices, and one that sees a 10 percent gain.

“Roughly speaking, the bull case would be consistent with the Aussie approaching 85 U.S. cents by end 2019,” Fabo said. “The bear case could see the Aussie decline to the low 70’s over that period.”

--With assistance from Garfield Reynolds

To contact the reporter on this story: Michael Heath in Sydney at mheath1@bloomberg.net.

To contact the editors responsible for this story: Nasreen Seria at nseria@bloomberg.net, Chris Bourke

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