by Craig James

How do you determine the “appropriate” level of a currency? This week we released the latest CommSec iPad index – an index that shows iPad prices across the globe. The index works on the theory that prices of the same goods should trade at exactly the same price in each country once exchange rates are applied. That is, if exchange rates are set appropriately. The Economist “Big Mac” index works on the same principle.

While all this makes sense in theory, clearly other factors apply in practice. And that’s why Purchasing Power Parity (PPP) is just one of the theories that apply in currency markets to determine if a currency is over-valued or under-valued. PPP actually tends to be more of a light-hearted approach to assessing currency relativities rather than a rigorous theory. Still, it should get you thinking about why currencies are trading where they are.

Another currency approach is the real effective exchange rate, a rate that takes into account relative trade balances between countries and inflation rates.

But clearly trade and inflation are just two of the factors that determine a currency’s value. And there are specific ‘hot button’ issues that are important for particular currencies. For instance the Aussie dollar is regarded as a “commodity currency” given that raw materials dominate exports. So current and future commodity prices serve as a guide to where the Aussie dollar is, and where it’s going.

Arguably capital flows are more important nowadays so relative interest rates, credit ratings, politics, expected and current economic growth are key currency determinants.

But it also isn’t one-way traffic. Analysts are assessing all the relevant factors for every currency and it is the relative strength or weakness of those factors that determines where currencies trade.

The week ahead

The “top shelf” indicators return in Australia in the coming week. In China the performance of manufacturing indexes are released. And in the US, arguably the most important monthly indicator – the employment or non-farm payrolls data – is issued.

In Australia, the week kicks off on Monday when the Reserve Bank releases the Financial Aggregates publication – a report that includes private sector credit or loans outstanding together with money supply indicators like M3. Credit probably lifted 0.4 per cent in August or 3.4 per cent over the year.

On Tuesday the Reserve Bank Board meets and it would be surprising if interest rates aren’t left unchanged and the accompanying statement isn’t a near copy of the September decision. Over the past month literally all the domestic and global economic news would have given the RBA comfort to stay on the sidelines for at least another month.

Also on Tuesday retail trade data is released. After a five month period when spending went backwards, we expect that warm weather would have encouraged some early Spring-related spending. Retail trade is tipped to have lifted 0.4 per cent in August, but that would still leave spending broadly flat over the past six months. The Performance of Manufacturing index is also issued on Tuesday.

On Wednesday, August international trade figures are released alongside building approvals data for the same month. Decades ago the trade figures mattered, especially for currency markets. Now traders barely bat eyelids at the export and import figures. We expect that the trade deficit narrowed from $800 million to $400 million.

The building approvals data is arguably more important nowadays, serving as a leading indicator for home and commercial building. The problem is that the data is ‘lumpy’ with approvals down 10.6 per cent over May and June only to rise 10.8 per cent in July. We expect a 3 per cent lift in approvals in August.

On Thursday, the Performance of Services index is issued alongside data on new car sales. Little improvement is expected in the services gauge in September, but certainly readings are tipped to lift in coming months. And new car sales probably improved on confirmation that the fringe benefits tax provisions affecting cars won’t change.

In the US the week kicks off on Monday with the influential Chicago purchasing managers index and is followed up with the ISM manufacturing index on Tuesday. The ISM manufacturing index is well above the 50 line that suggests healthy growth. And the ISM reading is expected to have remained around 55.7 in September.

Also on Tuesday, data on construction spending and new auto and truck sales are released together with the usual weekly chain store sales reports.

On Wednesday the ADP report on private sector employment is released together with the weekly report on mortgage transactions – purchases and refinancing. Economists expect that private sector jobs rose by 180,000 in September after a 176,000 increase in August.

On Thursday the weekly data on claims for unemployment insurance is issued together with factory orders, Challenger job layoffs and the ISM services index. The ISM services index may have eased from 58.6 to 57.0 in September, but any reading above 50 signals expansion in the services sector.

And on Friday the monthly employment report – non-farm payrolls – is released. After peaking at 10 per cent in October 2009, the jobless rate has now eased to 7.3 per cent, and on the current pace, it will be below 7 per cent by end year. Economists expect that non-farm payrolls lifted by 177,000 in September, up from the 169,000 gain in August. And the jobless rate is expected to have remained at 7.3 per cent although risks are to the downside.

Outside the US, in China, HSBC will release the final estimate of its purchasing manager’s index for September on Monday while the “official” PMI gauge (from the National Bureau of Statistics) is issued on Tuesday. And on Friday the HSBC services gauge is issued.

Sharemarket, interest rates, currencies & commodities

Do financial markets place any chance on another rate cut? The answer is yes, but not with any great certainty. At the upcoming Reserve Bank Board meeting, financial markets believe there is an 8 per cent chance of a rate cut, backing up the ‘broadly unchanged’ view from market sector economists.

The chance of a rate cut at the November meeting isn’t much higher at 14 per cent, although a 58 per cent chance is placed on a rate cut at some point over the next nine months.

Turning to the 90 day bank bill futures market, the implied yield on 90 day bills in December is 2.52 per cent, which compares with the current 90 day physical yield of 2.57 per cent. The implied yield on the March 2014, 90 day bank bill futures contract is 2.50 per cent.

Last week we lifted forecasts for the ASX 200 and All Ordinaries indexes. At the end of 2013 we now expect both indexes to be around 5,400 points and 5,600 points in June 2014. While there is still uncertainty about when the Federal Reserve will wind back monetary stimulus and there are the now usual wrangling in the US Congress on the debt ceiling and budget issues, the global economy continues to heal.
 
Upcoming economic and financial market events

Australia

  • September 30 - Private sector credit (August) - Credit probably grew by 0.4 per cent in the month
  • October 1 - RP Data/Rismark home prices (September) - Sydney and Perth have been leading the price gains
  • October 1 - Reserve Bank Board - No change in rate settings is expected
  • October 1 - Retail trade (August) - Spending may have picked up; a gain of 0.4 per cent is tipped
  • October 2 - International trade (August) - A $400million deficit is forecast
  • October 2 - Building approvals (August) - Another 3 per cent lift in approvals is expected

 
Overseas

  • October 1 - US ISM manufacturing (September) - Economists expect the index to edge up from 55.7 to 55.8
  • October 2 - US ADP employment gauge (September) - Private sector jobs are expected to have lifted by 180,000
  • October 3 - US ISM services (September) - Analysts expect a fall in the index from 58.6 to 57.0
  • October 4 - US Non-farm payrolls (September) - Job creation of 177,000 is tipped; jobless rate 7.3 per cent