By Jo Masters

After a turbulent few months, the Australian dollar finished 2014 at US82 cents, a fall of over US7 cents in the year. A weaker Australian dollar was widely expected, although the timing and speed of the depreciation saw some scramble to re-position.

You do not need to look too far, or dig too deep, to find solid reasons why the Australian dollar is weaker. Most obviously, commodity prices - which remain a key factor in fundamental assessments of the local currency – have fallen sharply. Iron ore, oil and copper are all down at five-plus year lows. 

 

Source: Yahoo Finance

In addition, despite the most recent employment numbers, the risks around the domestic economic outlook have shifted to the downside. The key challenge for the Australian economy has – and will continue to be – the shift away from resources towards more traditional drivers of growth. 

On the one hand, the commodity sector has weakened faster and harder than expected. And on the other, consumer and business spending has failed to pick up as fast as expected. Housing is a bright spot, although the latest building approvals and housing finance data suggest this sector may have come off the boil. The economy expanded at just 2.7% in the year to September, and inflation expectations have slipped to five-year lows. 

Several economists are now expecting the RBA to ease monetary policy, with one to two rate cuts by mid-year. Futures markets are pricing in a 70% chance of a rate cut by April, and 100% chance of one by June.

Against this backdrop, it is no wonder the Australian dollar has weakened. However, the downward momentum is likely to ease up over the first half of 2015. That is not to say the Australian dollar won’t go lower, but that the pace of downward momentum is likely to moderate, particularly as speculative longs have already been washed out. 

Traditional ‘fair value’ models for the Australian dollar - which incorporate commodity prices, interest rate differentials and the current account – suggest ‘fair value’ is around US80 cents. Obviously, the more commodity prices fall, and the more interest rate differentials with the US narrow, the lower this number will be. 

One key support for the local currency – and one that will limit downside in the coming six months – remains the fact that the local cash rate is one of the highest among advanced economies (see table). 

While the differential against US interest rates will narrow – and faster than many had thought as domestic views shift toward rate cuts from the RBA – the reality is investors still have to pay to be ‘short Australian dollar’. Even if the RBA cut the domestic cash rate to 2%, it’ll take the Fed a good while to catch up. 

Moreover, there aren’t too many currencies that look like a better buy than the Australian dollar. Sometimes you don’t need to be a stand-out, just the best of a bad lot. The US dollar is the stand-out for this year, although most are already positioned for further US dollar strength.  Kiwi rates make the NZ dollar attractive too, and perhaps if you need exposure to Europe then STG (the British pound) is the currency of choice. But that’s about it amongst the majors. 

The euro will battle ongoing concerns about the economy, and more importantly, the commencement of quantitative easing by the European Central Bank (ECB). The US dollar is a great example of the impact that quantitative easing programs have on currencies. And, some believe that last week’s shock move by the Swiss National Bank is a sign that the ECB may undertake a larger than expected easing program. Meanwhile, the Japanese economy is faring little better. 

So, with long positions already cleared out in the Australian dollar, the local currency should find some breathing space in coming months. In the near term, look for the Australian dollar to find support ahead of 0.80 (particularly if commodity prices continue to show signs of greater stability). Looking toward the middle of 2015, look for the Australian dollar to move toward 0.77. More broadly, the Australian dollar should fare well on some of the cross-rates, particularly against the euro and yen.