From time to time, the mainstream media will elicit headlines to stir the pot, pointing to the Australian dollar depreciation to 65 US cents or even 60 US cents. Whilst this may be a spotlight grabbing headline that actually results in constructive thought and discussion on the topic, it is important for everyday investors to understand the dynamics at play and to ensure that they make the right decisions regarding their own portfolios.
If we remove the most recent “flash crash” that was caused more by market malfunction, stop-loss triggering and holiday liquidity than any fundamental analysis, AUDUSD has more-or-less traded between 0.7000 and 0.8000 for the last four years. Without a large-scale global event (as opposed to a threat of an event), there is no reason to believe that, with the Fed on a slower hiking trajectory, this range will not hold for the rest of 2019.
Whilst some factors such as Brexit, US interest rate rises and the initial China-US trade war may add to market instability, there are many other drivers that contribute to the actual trading value of the AUDUSD foreign exchange (FX) rate.
All of those global risks mentioned above are priced into the current FX rate, however years of quantitative easing, effective monetary policy and political manoeuvring, to guide global markets through the last 10 years since the GFC, have smoothed risk fears. As a result, FX markets are less volatile than they were at the start of the decade.
The ability for central banks and politicians to “kick the can down the road” and extend QE or moderate market jitters, has helped the global economy splutter on in a “relatively” healthy manner (depending on which country you focus on!!) For this reason, the risk of a big drop in the Aussie dollar is priced by FX professionals at a lower probability than it would have been 7-8 years ago.
The pound/US dollar cross — GBPUSD — did fall off a cliff after the original Brexit referendum (and the market was pricing in a lot of risk for this event), however even GBPUSD has been able to hold in there above 1.2500. The options market is even pricing for a positive Brexit result and many players are calling for sterling to appreciate to 1.40-1.50 GBPUSD by the end of the year (where it was at the beginning of this journey). A testament to the FX market’s current optimism in politicians and central banks!
In addition to a lower risk premium being priced into FX, the structural characteristics of AUDUSD lend to the continuing of the current range.
Corporations and exporters play a big part in the FX market for insurance and risk management purposes. I think that it is an important element to consider so that we can truly understand the real money interest and demand dynamics.
With the Aussie currency trading within a well-defined range over the last four years, there is less willingness from a corporate treasury department to take any excessive currency risk and try to extract extra profitability from FX speculation (a non-core business).
Let’s couple this risk aversion with the idea that budget projections for these companies will be based on a currency rate of 75 cents (the middle of the recent range). Now, for big multi-national exporting companies, with very large international currency requirements, any move lower in AUDUSD will represent more profitability. This is because Australian products are now cheaper on the global market, and thus more competitive, and any offshore profit is converted back to Australia at a better conversion rate than budgeted. So, if the company can lock in this lower Aussie FX rate, the company’s profit streams will be higher than forecasted.
As such, these moves lower in the currency rate will continue to see exporters buying the currency and locking in these profits against “budgeted” forecasts.
These buy orders compete against speculative selling pressures. And when you think about which exporters are in this market and what size orders they have, think of companies such as BHP and Rio Tinto and you can understand the real impact this demand has on the market.
On a more complex note, market participants also use derivative tools, such as options, to hedge risks or as speculation plays. The AUDUSD options market is, for many reasons, currently positioned to profit from moves lower in the currency. This is particularly prevalent around important technical levels such as 0.7000. What this then tends to create on any move lower is buying pressure, as option holders look to “take profit” of derived profitability from the downward move. (i.e. their option is starting to pay off and they need to lock those pay-offs in).
On a final note, corporates also use derivatives and options as a part of their hedging strategies. Simply (and without getting into the technicalities), if a company sells options, they can effectively lock in a more advantageous currency conversion.
With the effect of QE and monetary policy that we have talked about before, we have seen a steady decline in AUDUSD volatility over an extended period of time.
So, with volatility declining, who wants to buy it!? Most hedge funds don’t. Most speculators don’t. But banks have to show prices for corporates still. So now the banks are being given all of this volatility risk from corporates. In normal circumstances there would be a fair marketplace, however nowadays, most market participants are all positioned the same way – they want to sell volatility!
Therefore, any movement in the underlying FX rate, or any movement in volatility is quickly jumped on by market participants, and specifically banks, as an opportunity to offload some of their risk. This limits any meaningful changes in the exchange rate and explains why the Aussie dollar has struggled to break out of its broad range over the last 4 years.
What could change the status quo of the last 4 years? The Fed raising rates too quickly, a trade war collapse, a Brexit no deal or the RBA being forced to cut rates aggressively. All these are events that would change the dynamic of the AUDUSD landscape. However, the threat of an event will not be enough. To shake the structural dynamics of the Aussie dollar we will need a substantial and scary risk-off event.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
