by Joanne Masters

Financial markets have woken from their slumber, with the past month or so seeing dramatic moves across currencies, equities and bonds. The Northern Hemisphere is back from summer holidays, economic data has offered some surprises and thoughts are turning to what 2015 could bring.

The Aussie dollar has not escaped the volatility, falling over US 7 cents since early September to flirt with January’s low of US 86.60. Renewed price action and volatility stand in contrast to the preceding months, where the Aussie stuck firmly in a tight range, despite shifting economic fundamentals. Meanwhile, the Australian share market has fallen nearly 10 per cent.


 

Many economists and analysts had been calling for a weaker Australian dollar for some time (although the speed and timing of the move may have caught many by surprise). You don’t have to look too hard to find reasons to be ‘bearish’ about the Aussie. After all, commodity prices are under pressure, growth in our key trading partner is slowing, the Reserve Bank of Australia (RBA) is firmly on hold and geopolitical risks are heightened on a variety of fronts.

Global prices for iron ore – our largest export – have fallen 40 per cent, with further downside likely, as major producers flood the market with supply. Meanwhile, news that China will impose tariffs on coal has added to the sombre outlook.

Locally, the economy is still struggling to transfer from mining-led to domestically driven growth. The RBA is widely expected to maintain current interest rate settings until 2016, but arguably the risks have accumulated to the downside over the past month. Indeed, the labour market has disappointed, with the unemployment rate up and wages growth weaker than expected. Meanwhile, the expected fiscal drag on the economy could be larger than forecast, given slower than forecast wages growth, lower iron ore prices and higher than planned military expenditure.

The key story in currency markets, however, remains the US dollar. Indeed, the Aussie dollar has ignored this background fundamental story for much of 2014.

There’s no doubt that sentiment has turned in favour of the US dollar as the Fed’s quantitative easing program draws to an end and the market can sense the proximity of US rate hikes.

Selling US dollars against almost any other currency is no longer attractive, particularly as financial markets are reminded of the significant risks and challenges to the economic outlook for both Europe and Japan.

All this said, it’s unlikely to be a smooth recovery path for the US dollar or a steady decline for the Aussie. Volatility has risen, positioning has squared up, geopolitical risks abound and adjustments are rarely orderly and streamlined.

Indeed, market confidence in America’s economic recovery (and the timing of rate hikes) wavered after the release of the minutes from the latest Fed meeting, which expressed some concern about the impact of a slowing global economy and stronger US dollar on the US recovery. This has seen US 10-year yields slip from 2.65 per cent back to 2.30 per cent, and with US equities also under pressure, has temporarily taken the gloss off the US dollar.

Equally, while the Aussie may be under pressure from a stronger US dollar, commodity prices, concerns about elements of the local economy, and risk aversion, it remains supported by ‘yield chase’.

The world is still awash with liquidity and the Aussie dollar remains a standout on yields. Even as the Fed commences rate hikes, the Aussie (as well as NZ dollar and Sterling) will continue to offer sound relative returns – particularly with Europe and Japan expected to maintain zero interest rates for a long time to come.

Coming months will continue to be a story of US dollar strength, although there will be periods of range trading, periods of volatility and periods of sharp moves depending on economic data, on sentiment and on positioning.

Against this backdrop, however, look for the ‘coupon story’ to provide some relative support for the ‘yielders’, specifically the Aussie, NZ dollar and Sterling. It will be easiest to hold long US dollar positions against the Japanese yen, Euro and Swiss franc.

With positions cleared out, and the US reporting season on the doorstep, currency markets are likely to take a breather, with the Aussie likely to establish a range of 0.85-0.90 for coming months.