Driver 3 – Downward Pressure on the USD
The sustained depreciation of the USD was a significant trend movement throughout 2020. This price trend on a bilateral front, is a driver of the AUD’s appreciation. This outcome was accurately projected for two key reasons; record high quantitative easing measures in the US and a decreased funds rate level.
Th US Fed bought $1.5tn worth of government bonds, effectively monetising 100% of their new federal debt accumulated during the initial March economic downturn. Over 2020, the US government added $3tn to its balance sheet, materially paving the way for a weaker currency and sustained depreciation throughout 2020.
Along with Biden’s proposed $1.9tn COVID-relief stimulus package and expected second stimulus bill, quantitative easing may be again called upon to offset the adverse implications of high sovereign debt. However, the potent threat of high servicing costs derived from high sovereign debt could create a debt trap scenario and perhaps be the catalyst for a shift in the buoyant sentiment and bullish herd mentality in the midterm.
Compounded with these factors, the low Fed rate has led to capital outflow as investors seek greater returns in other markets via an interest rate differential strategy. Hence, on a bilateral level the AUD has appreciated in part due to the downward movement of the USD.
Movements in currencies had flow-on effects on equity markets, as companies who have part or all of their revenue coming from US markets saw decreased profits in terms of the AUD, even if they generated better revenue. There are several Australian companies whose revenue stream remains heavily exposed to USD price movements.
Australian healthcare, being a globally diverse sector, is an area where this is the case with 55% of CSL’s revenue and 65% of Resmed’s generated in the US. Resource majors BHP and Rio although reporting in USD, are driven more so by commodity prices. Commodity prices are quoted in US dollars and tend to move in opposite directions to the USD. In effect, any depreciation of the USD tends to be offset by increases in the price of the underlying commodity itself. This impact is similarly applied to the energy majors such as Woodside Petroleum and Oil Search
What drives the inverse relationship between the USD and commodity prices?
Since commodities are quoted in USD terms, if the value of the USD were to depreciate, this would decrease the purchasing power and ‘true value’ of the currency. Hence, a market participant would then require more of this devalued currency to purchase a commodity which has held its value. As an example, if the USD depreciated by 10%, ceteris paribus (all other things remaining equal) iron ore prices should be quoted 10% higher to offset the decrease in value. It is crucial to note that ceteris paribus does not exist in the real world and thus allows the ebb and flow of financial markets to, at times, cultivate an opaque realisation of this relationship due to a myriad of counteracting forces and drivers.
Driver 4 – Australia S&P/ASX200 Stock Market Index
ASX200 index in the last year via tradingeconomics.com
An increase in capital inflow into equity markets is a fourth driver of the dollar’s upward pressure. This notion is exemplified through an analysis of the AUD’s correlation with the ASX index. The XJO fell from highs of 7,100 points down to 4,500 to in a matter of weeks during March (a 37% decline) catalysing a depreciation of the AUD/USD from 0.66 down to 0.54 during the same period.
The curtailment of confidence surrounding COVID in its initial reporting provided the impetus for a market sell off and the capital flight experienced in the ASX. As a large portion of Australian equities historically are owned by foreign capital, this causal analysis bears great weight and is supported by the evidence of both of the index measures being correlated throughout 2020. Since the March lows, both indices have increased with the ASX 200 index approaching the 7,000 basis points and the AUD rising to 79.7 cents per USD.
As indicated above, there has been a strong correlation between the performance of the ASX 200 and the AUD/USD movement. This relationship, when compared using month on month percentage changes, is captured through a correlation statistic of 0.89, suggesting a strong relationship between the movements of these markets.
During the market sell off institutional money may have moved overseas and converted into other FX denominations (most obviously the USD, which is seen as a relative safehaven) , which increased the supply of AUD in FOREX markets. In similar fashion, during the ASX recovery, international investors had to demand the Australian dollar in order to purchase Australian equities, which in turn led to an appreciation of the AUD.
Driver 5 – Record Private Savings
Another reason for Australia’s appreciation could be record high savings rates during 2020. Australia’s household savings ratio increased to 22.1%, a high not seen since data collection started in 1950. This has had material effect on Australia’s savings and investment gap which has been the major contributor as to why Australia has historically been known as a ‘net importer of capital’.
Traditionally, Australia’s low savings rate and high investment injections have meant that net foreign liabilities have been high with debt and equity proceedings being used to fund these investment activities. This has put downward pressure on the AUD due to capital outflows in the form of servicing costs in the form of dividends, interest repayments and profits.
Historically, issues surrounding debt were counterargued in line with economist John Pitchford’s ‘consenting adult thesis’, which expressed that consenting adults were making debt decisions in line with their appetite and capacity to repay their borrowings where they fall due. In turn, high debt levels in Australia were not a threat if it was drawn, in majority, by rationale private agents.
In delineation, although private saving has increased, public saving has drastically decreased with expansionary fiscal policy resulting in reduced taxation revenue and increased government spending. This could even lead to a twin deficit hypothesis scenario where government deficits will in turn lead to current account deficits and in turn put downward pressure on the AUD in the midterm via capital outflows.