Where to for the Aussie dollar?

ROADHOUSE REGULAR: Acuity Capital’s Stephen Earl takes a look at expectations for the Australian dollar and what this means for resources companies.

The Australian dollar performed superbly during the mining led boom of the 2000s.

Its rise from 65 cents in January 2000 to above parity in December 2010 – a period which also included a jarring if short lived correction during the global financial crisis – ensured that inflation in Australia was kept in check, allowing the Reserve Bank to moderately rather than drastically increase interest rates over the period.

This provided for a strong and stable business environment in which Australian companies could confidently grow and ultimately thrive.

 

The performance of the AUD over recent times has, however, been a little less ideal.

Until very recently, the dollar has remained stubbornly high in the face of a deteriorating Australian economic landscape, thereby failing to deliver the critical benefits Australian exporters – resources companies chief among them – so desperately crave.

Its fall from above parity to around 90 cents over the past few months has gone some way to addressing things, but not as far as many would expect or like.

In fact, the Reserve Bank itself recently said that the dollar is, “still a bit too strong to help, to the extent it could, in the transition [the Australian economy needs] to make”.

The factors in play
In order to understand what might happen to the Australian dollar going forward, we need to look at its key drivers.

While there are many factors which influence FX rates, the key parameters to consider are: interest rates; general economic conditions; and sentiment.

As far as interest rates are concerned, momentum is certainly pointing to a downward currency move.

As well as recently cutting our benchmark overnight cash rate to a record low 2.5 per cent, the RBA indicated it still maintains a downward bias for the cash rate.

This, coupled with the RBA’s explicit and repeatedly stated want for a drop in the exchange rate, bodes well for a decline in the AUD as ‘yield seekers’ move to higher yielding currencies or other assets.

General economic conditions also point to a drop in the Australian dollar.

While it is a stretch to call the Australian economic situation bad, the economy certainly has less momentum now than in past years largely due to mining infrastructure investment having passed its peak.

Australia’s terms of trade in particular have come off over the past twelve months on the back of a drop in resources prices and a slowdown in China, pointing to reduced demand for the dollar from our trading partners.

As in all economic analysis, sentiment is the great unknown. Unfortunately, the fact that sentiment is hard to predict does not mean it is not influential: the general level of Australian dollar love / hate can have a marked effect on the exchange rate and can act quickly to turn a trending market on its head.

Where to next?
What the Australian dollar should do is, of course, all well and good, but the real question for business is what will it do?

According to Bloomberg, currency analysts are divided on where the Australian dollar is headed over the next two years. If we look at all analyst forecasts made since the Reserve Bank last met and cut interest rates, we get the picture below.

 

What this says is that, while some analysts believe the currency could again hit parity and remain there for some time, the bulk of analysts see the rate slowly decreasing over the next two years.

Average expectations are that it will finish this year around 90 cents, finish next year around 88 cents and then fall further to 87 cents in 2015.

A significant number are, however, predicting a much steeper decline, with some analysts expecting a rate of less than 75 cents by 2015.

Given the headwinds the currency faces, it is perhaps surprising that analysts are not more biased towards the downside.

In fact, many experienced market players are expecting a far lower rate than the average analyst in short time, with Bloomberg reporting large amounts of sophisticated money heading to hedge funds with expectations of a rate of 75 cents.

Perhaps most critically of all, the one player with real influence in the space, the Reserve Bank of Australia, is very keen to see the AUD fall, suggesting some real firepower sits behind a slow and steady AUD depreciation.

What does this mean for resources companies?
For Australian resources companies, the good news is that expectations of a fall in the Australian dollar mean that fortunes may finally be turning.

As to exactly how big a turn they take, it all depends on where and how you play.

For resources companies with Australian assets, a drop in the Australian dollar is all good news.

The value of minerals exports, virtually all of which are denominated in US dollars, increases in Australian dollar terms with a depreciation in the FX rate, meaning more Australian dollar revenue for a given Australian dollar cost base.

This increases profits as well as providing a buffer against any downturn in global minerals prices, greatly nullifying what many believe to be the key risk faced by the resources sector.

For resources companies with assets outside of Australia, the picture is good overall but a little more mixed.

Assets in emerging markets tend to imply a US dollar cost base (or a cost base in a currency pegged to the US dollar), meaning the benefits of the drop in the Australian dollar extend only to the profits on the minerals extracted rather than on the entire mineral revenue.

This is, of course, still great news, but there is an added complication in needing to get a handle on expectations for the exchange rate of the asset currency itself, something which could have markedly different drivers to the Australian dollar.

The wash up
The bruising twelve months experienced by the resources sector may not be altogether over, but the prospect of a drop in the Australian dollar offers new hope.

In short, the depreciating dollar means there is a ray of light at the end of the resources tunnel.

Stephen Earl is a Director at Acuity Capital, an Australian based provider of capital raising solutions for ASX-listed companies. For more information,visit acuitycapital.com.au or email info@acuitycapital.com.au.