R.B.A to Leave Australian Dollar to its Own Devices

Yes, policy makers at the Reserve Bank of Australia (RBA) are concerned over the strengthening Australian dollar, but will they do anything about it?

Since the last RBA meeting, the Aussie dollar has strengthened roughly 6.5% against the US dollar and 5.7% against the Chinese yuan ensuring the cost of Australian produce and services on the international market has become notably more expensive.

At the April RBA policy meeting we got confirmation that the stronger currency is becoming a worry to some of the most important economic decision makers in Australia.

"The Australian dollar has appreciated somewhat recently. In part, this reflects some increase in commodity prices, but monetary developments elsewhere in the world have also played a role. Under present circumstances, an appreciating exchange rate could complicate the adjustment under way in the economy," read a statement from Glenn Stevens, Governor of the RBA.

This replaces the previous month’s comment that “the exchange rate has been adjusting to the evolving economic outlook.”

The currency's strength is therefore a threat to the RBA's goal of shifting the Australian economy from one that is reliant on mining and mineral exports to one that is more dependent on the consumer and manufacturing sectors.

The Australian dollar actually rallied in the wake of the event, delivering a classic sell the rumour buy the fact response.

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Will the RBA Actively Fight the Australian Dollar's Strength

At the G20 Summit held in China in February finance ministers and central bankers pledged not to devalue their currencies and it would therefore be highly unusual for the RBA to risk its credibility by taking overt policy measures to halt the Aussie dollar's rise.

Cutting and raising interest rates is therefore the only concrete policy measure that the central bank can take. Australia currently has a basic lending rate set by the RBA at 2.0%, one of the highest in the developed world.

This attracts gargantuan inflows of investor capital seeking out better returns than would be achieved, for instance, in the UK where the basic rate is only 0.5%.

Cutting rates would diminish this dynamic and see demand for the AUD fall.

However, the problem with cutting rates is that it risks fuelling the Australian housing market further as cheaper lending could inflame what is already considered a too-hot-to-handle housing market, particularly in Sydney.

“Given the RBA’s assessments of the causes behind the rally in AUD (commodities and other central banks' monetary policy settings), they seem disinclined to cut rates purely on this basis and are likely to wait for these temporary factors to dissipate and let the Aussie drop back to a sub-US$0.70 level on its own,” says Angus Nicholson at IG in Melbourne.

It seems then that verbal threats against the Australian dollar is all the RBA have at their disposal at present.

“Some in the markets were clearly expecting a stronger jawbone or even a rate cut,” says Nicholson.

In fact, some would argue that the RBA is not actually losing any sleep over the issue.

“These comments are consistent with our view that, while the Bank is likely to be uncomfortable with the exchange rate at current levels, it is unlikely to react in a mechanical fashion to the stronger dollar. Rather, it will be looking for evidence in the data that the level of the currency is turning into a headwind for growth,” says Felicity Emmett at ANZ Research.

As we have seen in the past, unless verbal intervention is followed up by a policy response it is ultimately meaningless.

The RBA knows this and will likely keep a subdued tone on the currency front until such a time that they believe  they are ready to cut rates agressively to address the rising currency.

Australian Dollar Now Overvalued

The RBA will also be confident of the market's ability to punish their currency if it gets ahead of itself.

This rise from the 0.70s to 0.77s has got some institutional analysts concerned that the Aussie may already be ‘overpriced’.

Robert Rennie, a strategist at Australian bank Westpac recently questioned the head of the RBA, Glenn Steven’s on whether he thought the AUD/USD pair had now entered a ‘higher plane’ in the 0.76/77s.

Stevens answered broadly that he thought the Aussie may have got “a bit ahead of itself”:

“Unless you think that the commodity price trend now is different and we are heading back to a world of considerably higher prices for an extended period, and you think the Fed is never going to lift rates, it is not clear that that situation will warrant a much higher exchange rate than this and there is some risk actually that the currency might be getting a bit ahead of itself.”

The AUD has been in decline over recent days with signs that speculators are starting to sell the AUD in anticipation of further falls.

A clear sign of the currency's overvaluation can be found in moves in its relationship with the copper price.

We note that of late the two have detached with the AUD now looking to high when compared with the price of copper.

Add to this views that copper strength is set to end, then the outlook argues for a lower currency, with or without the RBA's help.