By Joanne Masters

Financial markets are often described as ‘dynamic’ and ‘exciting’ and the past month or so has shown just why.  Significant moves across asset classes, volatility, sharp shifts in positioning and headline grabbing news – its all been there.

Currency markets are no exception. We’ve seen significant falls across currencies, with the Japanese Yen at a seven-year low, the Aussie fall to four-year lows, the Euro to two-year lows and multi month lows on the NZ dollar and the Pound.

US outlook rosy

The overwhelming story is improving confidence about America’s economic prospects, and along with that, the prospect that the US Federal Reserve starts to raise interest rates next year.

This story has been gaining momentum, and was given another shot in the arm last week with November payrolls data. The data revealed a staggering 321,000 new jobs were created in November, smashing economists’ forecasts and up from a positively revised 243,000 new jobs the previous months. Unemployment was steady at 5.8% and, encouragingly for policymakers, average hourly earnings rose 0.4% in the month, double expectations.

The US is on track for the best year of jobs growth in 15 years, and latest growth forecasts from the well-respected National Association of Business Economists show economic growth accelerating to 3.1% in 2015, up from 2.2% this year.

In addition to a broad-based rally by the US dollar, US yields have also risen as investors have become increasingly confident the US Fed will raise rates in the first half of 2015. Financial market participants will be looking closely at the statement from the FOMC on 16-17 December for any hints that rate hikes could be sooner rather than later. The US dollar will get another boost if the FOMC alters its long held statement that maintaining current interest rate settings will be appropriate for “a considerable time”.

Everywhere else

In contrast, the economic picture in Japan and Europe remains worrisome. The Bank of Japan surprised financial markets at the end of October with its decision to flood the market with cash to counter deflationary pressures. Meanwhile with economic growth in the European Union slowing to an annual rate of just 0.8% in the September quarter, the ECB is reported to be considering an asset purchase program of Euro 1,000 billion.

Against this international backdrop, and with commodity prices plunging, its little wonder that the Aussie is under pressure! Indeed, the Aussie dollar has not just slipped against the resurging US dollar, but has loss ground against the Euro, the Pound, the NZ dollar and has only held steady against the collapsing Yen.

On commodity prices, it’s enough to say that both iron ore and oil are sitting at five-year lows. And the adjustment has been quick, with iron ore prices nearly halving in a year. This is hitting Australian equities, state and federal budgets, the economy and confidence.  Indeed, recent national accounts data showed that the economy expanded by just 0.3% in the September quarter (missing forecasts of 0.7%) and resulting in annual growth of 2.7%.

Rate cut possibilities

If that is not enough to hurt the Aussie, talk has turned to the prospect of a rate cut from the RBA next year.  Indeed, financial markets are now pricing in a 60% chance of a 25 basis point rate cut next year, possibly as early as February. Several economists are now on board with this view, with one domestic bank looking for consecutive 25 basis point rate cuts in February and March, which would take the local cash rate to 2%.

And as if this trifecta – of a strengthening US dollar, plunging commodity prices, and talk of local rate cuts – is not enough, market risk and volatility are also weighing on our ‘fair weather’ currency.  At the margin, so is the recommendation from David Murray’s Financial System Inquiry that Australia’s big four banks need to increase their capital holdings to protect themselves from a future financial crisis.

It is difficult to see the Aussie dollar garnering much support any time soon. With trading volumes likely to decline in to the holiday period, investors will be cautious about holding risky positions. The technicals are bearish, the fundamentals poor. I am looking for the Aussie dollar to find support above 0.80 over the remainder of this year, at least while domestic interest rate expectations firm up.

With deteriorating fundamentals, how low can it go? Well, with the Aussie still paying coupon, it’s hard to see a re-run of the rout that hit in 2009. Fair value models suggest that the Aussie dollar should be around 0.77. Certainly that is possible – even probable – but I think that is a level for 2015.

Source: Yahoo Finance

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