Great news for Australian investors and the economy is that the Australian dollar finally appears to be re-aligning itself with fundamentals.

Note whether the Australian dollar rises or falls is not inherently good or bad – what matters is whether its moves are in line with what the economy needs. In times of strong demand and rising inflation pressure, it’s handy to have a strong currency that keeps a lid on import prices and dents demand in the trade exposed sectors. But when the economy is soft, we’re better off with a weak currency that can boost the competitiveness of those that export or compete with imports, even at the risk of some lift in imported inflation.

In the main, the history of the $A in the post-float era is that it has acted as a useful economic shock absorber – rising and falling at the right times. In the past year or so, however, this stabilising role had been undermined by extreme global monetary stimulus. This kept the $A high even in the face of a relatively weak local economy and falling commodity prices, all because our still quite low (by our standards) interest rates nonetheless remained much more attractive than the near-zero rates offer to investors elsewhere. 

With frothy local house prices, the Reserve Bank is reluctant to cut interest rates further to support the economy, and Canberra is not helping the near-term growth outlook with its quest to quickly reign in the budget deficit. Falling commodity prices meanwhile, are hurting domestic incomes and underpinning a large scale cut back in mining investment. As a result, a weaker $A is desperately needed once again to help stave off further gains in the unemployment rate much above 6 per cent.

Thankfully, however, the $A finally appears to be riding to the rescue – and it’s not before time. Last week the $A dropped below a critical support level of US92c, suggesting its downtrend from past highs of US$1.10 is resuming after an extended hiatus. The next stop is likely to be around US88c, and my call is that the $A could drop to at least around US85c by mid-2015.

Why the decline? For starters, currency traders have finally recognised that the price for our major export – iron ore – has slumped, thanks to rising supply and slowing demand. While a decline in iron ore prices from their once stratospheric heights has long been predicted, the falls in recent months has been faster than generally expected.

In turn, the slump in prices reflects the step up in local iron ore production and exports at a time when Chinese demand is slowing, thanks to what still seems only a cyclical weakening in housing construction.

The slump in prices also reflects the stubborn refusal of many high cost Chinese iron ore producers to quickly exit the market as many analysts predicted – likely thanks to subsidies from regional governments desperate to keep local economy activity ticking over.

According to recent analysis from the Reserve Bank of Australia, the marginal cost of iron ore production in Australia appears to be around US$50 tonne, meaning most producers are still profitable even at current low prices – although they’re making much less money than they might have hoped. But producers in many other countries are losing money and their eventual exit from the market – assuming market forces prevail – together with a stabilisation in Chinese economy growth should eventually stem iron ore’s price slide.

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By far the strongest driver of the recent $A decline, however, is heightened fears that the United States Federal Reserve is about to signal a move higher in interest rates by early next year. The US economy is picking up nicely, and while there is still ample spare labour market capacity and low inflation, the need for 'emergency' level zero official interest rates has well and truly passed. 

The Fed must get a move on in raising interest rates lest it allow too many financial imbalances to fester – which in turn would risk repeating the mistakes leading up to the global financial crisis.

On current trends the Fed will wind back its bond buying program within the next few months, and turn its attention to both raising official interest rates and selling the swollen bundle of Treasury bonds it now holds back to the public.

While some may panic at the thought of monetary tightening, however, we should remind ourselves that this is good news. The Fed is only tightening because the world’s largest economy is getting better, not worse – and provided US inflation stays low, as I expect, it will only continue tightening for as long as the economy can take it. While Wall Street may well correct once higher interest rates loom into view, history suggest the early stages of monetary tightening need not threaten the bull market.  After all, America’s economy remains in the 'sweet spot', where growth is accelerating but there’s still enough spare capacity to keep inflation and interest rates still relatively low.

As for us, a weakening $A in the face of a stronger US economy and weaker commodity prices is just what we need. It’s taken a while, but the floating $A appears to be once again doing its job in helping stabilise the economy.