The Australian dollar has had a notable fall in recent months – and, in fact, these falls could start to
help economic growth by making trade-exposed sectors more price competitive. But while any
such benefit associated with falls may be true at the margin, this is only a partial analysis of the
overall effect on the economy – because the A$ is falling at a time when key export commodity
prices are falling also, undermining national income growth.
In this regard, the A$ needs to fall just to help offset the negative impact on the economy from
weaker export prices. The key question is whether the $A has fallen by enough. So far at least,
the answer is a definitive “no”.
Note that, over the March and June quarters, the terms of trade (price of exports relative to
imports) has cumulatively declined by 5.4% – reflective of the decline in spot iron ore prices. Iron
ore prices have fallen notably further in the second half of the year to date, suggesting the terms of
trade will also decline further. Based on the decline in iron ore prices, our modeling suggests the
terms of trade will decline by around 5% in the September quarter, and a further 2.5% in the
December quarter (assuming the average level of iron ore prices in the current quarter so far,
holds for the quarter as a whole.)
Based on these projections, our BetaShares $A valuation model – based on the Reserve Bank of
Australia’s own publically revealed methodology – suggests the $A still remains significantly
overvalued at today’s prices, despite its recent drop below US90c. Indeed, our model of the real
trade weighted exchange rate index (based on the terms of trade and real interest-rate differentials
between Australia and major advanced economies), suggests the index is now around 10%
overvalued – near the peak levels of overvaluation over the estimation period since the mid-1980s.
Similarly, our model of the real Australian dollar bilateral rate to the US dollar suggests fair-value for
the A$ was US79c in the September quarter, implying a massive 17% overvaluation given its average of US92.5c during the quarter. Based on the assumed level of the terms of trade, our assessment of fair value for the A$ this quarter is US77c, implying overvaluation of 13% given today’s bilateral exchange rate of US87c.
Against this backdrop, it’s little wonder the RBA is still keen to talk down the A$ when it can and
has pointedly not ruled out exchange rate intervention should it remain uncomfortably high relative
to fundamentals. The quantitative easing programs in both Europe and Japan are no doubt helping
keep the A$ artificially high, as is the United States Federal Reserve’s reluctance to begin the
process of raising official interest rates to more normal levels.
Indeed, we should not forget that despite the A$’s decline in recent months, this largely only
unwinds strength earlier this year – such that the A$ is so far flat for the year on the trade weighted
index basis, and only down 3% against the US dollar.
Investors wishing to express a view that the US$ should continue to rise against the A$ can
do so using our U.S. Dollar ETF (ASX: USD), which aims to track the change in price of the
United States dollar relative to the Australian dollar, before fees and expenses. For example, if the
US$ goes up 10% against the A$ (i.e. the A$ falls in value) the ETF is designed to go up 10% too
(before fees & expenses). More information on this ETF is available here.