Will Katrina Blow The US Dollar Down As Well?

Leaving aside the blow to the United State's prestige and national psychology, which is bound to be substantial, the effect of Hurricane Katrina on the US economy - and therefore its currency - will be damaging and unpredictable.

The first thing is that there is now almost zero chance of another rate rise by the US Federal Reserve Board this side of Christmas. Since the next three or four rate hikes have been priced into financial markets after more than a year of steady tightening, meeting after meeting, a pause in the Fed's monetary policy must have an impact on the US dollar.

But more than that, economists have already started cutting their economic forecasts in the wake of Katrina. Many have cut fourth quarter growth forecasts from 3.5 per cent to 2.5 per cent. Michael P. Niemira, chief economist at the International Council of Shopping Centres, says the US retail sector will face its toughest Christmas since the September 11, 2001, terrorist attacks.

The storm is estimated to have destroyed 500,000 jobs and will cost $100 million. It's true that rebuilding will tend to boost the national construction and engineering industries - in effect producing a massive transfer of wealth from insurance company coffers into the real economy - the effect of the disruption cannot be ignored.

And this is an economy already at risk. Debt levels of the household and government sectors are riskily high, and interest rates have been pushed higher as the authorities wrestle with a serious US coastal-property market price boom.

Even though that is unevenly distributed among the regions '” and appears quite mild, on average, compared with the speculation that Britain is experiencing '” there is a distinct and threatening connection between mortgage rates, housing prices and consumer behaviour in the US as the Federal Reserve attempts to remove the punchbowl from the unruly party. Indebted US consumers, as they sober up, will be in worse shape than almost anywhere else.

Most of the US’s Asian dancing partners, though they will get hiccups, now have the capacity to maintain their growth and employment momentum by diverting output to regional and domestic markets. This too is likely to boost the $A relative to the $US.

There is also the problem of oil prices, which, on top of the 33 per cent rise in calendar 2004, have risen about 40 per cent this year. While the effect on growth and inflation has so far proved remarkably mild in the US and Australia, it is incontestable that Australians adapt better and faster than their trans-Pacific cousins to persistently higher oil prices '” especially when, as is now the case, the rise is due to growing demand rather than artificially limited supply.

22 YEARS OF FREEDOM

In early December 1983, when most of today’s currency traders were in primary school, the Australian dollar was floated by Labor’s Treasurer Paul Keating. Its level would henceforth be dictated by supply and demand, not by a bureaucratic central planner.

This brave leap into an unknown future by an inexperienced new government revolutionised economic life and attitudes by exposing Australia totally, for the first time, to the world’s impartial judgement. The reasons for deciding to strip in public were complex and highly technical, and were hotly contested by many expert insiders.

The driving concept was that deregulated markets are better than politicians at forcing change for the better; and that a progressive and well-endowed economy such as Australia’s would improve faster when exposed to real foreign competition. If times were good and Australia behaved well, investors worldwide would be attracted to the allure of its assets and its currency would tend to appreciate; if it performed badly, then the $A would decline. Meanwhile, the benchmark against which the trading world continued to measure Australia remained the $US, the currency of the biggest and most successful economy. It was in this freely floating currency that most of Australia’s commodity exports were denominated.

That benchmark can, of course, rise and fall against other floating currencies as footloose capital moves around. The currency market, constantly reacting to an immensely complicated cocktail of influences, is the biggest, most liquid and most volatile market of all; even the mightiest currencies swoop and soar as those influences change power and direction. In that cocktail, among other ingredients, are actual and expected interest rates, economic growth, trade performance, inflation, labour costs, industry structure, profits, national saving rates, regulatory regimes and political factors, all of which help to fuddle the forecaster.

Though short-term currency movements may often look unpredictable and sometimes even chaotic as buyers and sellers jostle for position, their long-term trends are seldom random. These “long waves” are determined by the overall market perceptions of how well, or poorly, one nation is performing relative to another, and whether that relative performance is likely to continue.

There are bound to be plenty of “counter-trend” oscillations within that long wave as new factors come into play day-to-day and week-to-week, but these are mostly ripples (sometimes surf) that should only command the attention and commentary of professional traders. The long-term investor is more interested in whether the tide has turned.

Which brings us first, to whether the market tide has begun to flow in again for the $US (essentially against the weighty euro and yen), and, second, to whether the tide is beginning to ebb against the $A after its tremendous run to $US80 cents from its 48-cent low early in 2001. This seems to be the consensus of today’s gun traders, some of whom, as we know, backed this bearish view with great conviction (with their bank employers’ capital, and to their great cost) as the $A defiantly marched ever higher. Are these perpetual Australian bears (perhaps we should call them koalas) right at last? Or are they about to get carted out too because they have again failed to learn the difference between a cycle and a trend?

A comparison of the two economies hardly puts Australia into a bad light. The recent slip in GDP growth has been provoked by an overdue sharp moderation in consumer spending brought on by the Reserve Bank’s mild tightening of interest rates, which, in turn, has fed through into a consolidation of housing prices and a pullback in the rate at which people have been drawing down and spending the equity in their homes. This tap on the brakes seems to have restored the necessary balance to the domestic economy, and the Reserve is now confident further action will not be needed, at least for some time.

At the same time, Australia’s trade performance sucked growth out of the economy, export volumes slipping badly relative to the imports, even though its terms of trade (the ratio of the prices of exports and imports) continued to be extremely favourable. Import volumes had been booming on strong incomes, cheap credit and cheap imported manufactures, especially from Asia. And Australia’s open economy has been consistently dismantling its native manufacturing base as an inevitable and continuing result of the 1983 currency float. Meanwhile, export volumes have been hampered by physical problems in some overstressed bulk-handling ports and railroads as well as by the grinding effects of drought.

The external drag on the Australian GDP has now peaked. Unless export markets come apart as domestic demand growth rebounds into 2006, Australia’s overall economic expansion is set to return to its long-term annual trend of more than 3 per cent. And this should be sustainable for at least another two years without courting an inflationary surge as new investment growth displaces the earlier growth in consumption. If the forecasts are right, Australia will be recovering as the US slows. That relative economic accomplishment will boost the $A against the $US.

That is because of two things: Australia is a major net exporter of energy and, therefore, it benefits nationally from any rise in world energy prices; and its domestic energy taxes are so high relative to those in the US that they serve as a usefully blunt instrument to force consumption economies when prices rise. This means the Australian economy’s prospects, if oil prices remain high, are not likely to be hurt as much as those of many of its partners. And it can supply them with competitively priced oil substitutes '” natural gas, coal, and, increasingly, uranium '” with which to fuel their big economic ambitions, especially if the debate about mining and exports becomes more rational. Once again, a world short of energy is a major supportive factor for a trend revaluation of the $A.

So, there are few reasons to join the koala chorus that is singing down the currency. Apart from anything else, the Australian cost of living remains notably low when compared with other developed economies, and the inflation rate is modest enough to ensure that this favourable relativity will be maintained. By the crude reckoning of The Economist’s Big Mac index of purchasing-power parity, (by which the actual cost of a standardised hamburger in two countries’ local currencies is compared with their theoretical cost at the ruling exchange-rate), the $A is undervalued by at least 15 per cent against the greenback, even at this unflattering stage of the Australian economic cycle. A move to “fair value” by that measure would put the $A close to US90 cents.

By the more sophisticated calculations of the IMF and CIA, Australia’s adjusted economic output per head of population ranks it 13th in the world, just behind Japan and well ahead of all of the largest “hard-currency” Euro nations into which the many currency-trader koalas are presumably re-weighting. Given the prospective stagnation of both the euro bloc and Japan, especially in the context of high and rising world oil prices, such a preference is surprising.

The “technical” picture is even more intriguing. Because of the sheer complexity and number of the fundamental factors that have been referred to, almost all currency trading is done by reference to charts of past price behaviour, which capture a totality of market opinion in a visual and highly dynamic form. These charts demonstrate the long trends and the short cycles and sub-cycles mentioned earlier, and also show certain characteristic patterns that may be regular enough, some think, to be used as predictive tools. The concepts of “support lines” drawn under price trends, and of “resistance levels” that have blocked previous price advances, are essential to this technique of extrapolating the past into the future. The conclusion is that the technical position of the $A appears as if it will be strongly supported above $US72 cents, and that its upside potential '” if it can break above 80 cents, at its third attempt since early 2004 '” may carry it very close to parity with the US dollar.

This is very much a minority view, and not supported by “establishment” forecasters in either official or financial sectors. The consequences of such a breakout would be substantial for Australia’s economic performance as well as for interest rates and asset pricing. But the possibility cannot be discounted any longer as Australia’s economic cycle revives relative to the US’s, and as the $A again approaches the $US80-cent breakout zone. This is not a good time to be ruled by past bearish prejudices. It is a good time to keep your eyes open and to watch the tide.

ACTION PLAN

A $A breakout above US80 cents would confirm that the tide is still flowing strongly in Australia’s favour, as it has since the turn was confirmed in mid-2002. That would forcibly make a lot of sceptics optimists and add their buying weight to the demand for the currency. Under such conditions, there would be a strong chance of a price overshoot towards parity with the $US.

Any explosive upside move is unlikely to achieve parity before the middle of 2007. Unless it was clearly supported by the sort of positive fundamental developments that are expected, the price spike would be fragile and strongly resisted, and a pullback to the previous US80-cent resistance level would occur. The market would be highly volatile as new beliefs about the $A’s likely trading range were formed.

• Other things being equal, a big currency appreciation is strongly deflationary for the economy because it depresses import prices and creates additional price competition for those who compete against imports. Profit margins for most local manufacturers would be badly squeezed and their dividends might be exposed while they struggled to cut costs to stay in business. Domestic service providers would be less vulnerable to import competition.

• Because domestic inflation tends to fall, interest rates usually decline as well. This can help bond and share prices, as can be seen from how financial markets behaved as the $A rose strongly from 2001. But it is important that interest rates are high enough to begin with to be able to fall as fast as consumer prices '” otherwise “real” interest rates will go up until they choke off investment and economic activity. Luckily, Australia’s rates have plenty of room to fall '” more than America’s and much more than Japan’s. So interest-sensitive sectors should do well as the $A rises.
• A strong currency helps to mitigate the trade and inflation effects of an oil-price shock if energy is either imported or priced at “world parity”, as is the case in Australia. This again should protect Australian domestic consumers and asset markets relative to those of weak-currency neighbours.
• A revalued currency would act as a drag on Australia’s export performance and would create a big obstacle to future profit growth in the resources sector. Although the volumes of exports might not be harmed immediately, it would be harder to compete internationally and would almost surely mean a loss of market shares. This would create a shift in portfolio preferences towards domestic-demand stocks at the expense of exporters, and towards value stocks at the expense of growth.
• Finally, a stronger $A would make international shares more attractive and less risky to local investors if the timing was good. But a heavy re-weighting into foreign assets before the currency tide turns against Australia could prove an expensive mistake.