A number of factors help explain the fall back in the Australian dollar in recent weeks, and there’s an increasingly good chance the Aussie could finally be breaking to the downside, after an extended two-year period of trading just above parity to the US dollar.

The drivers

The Reserve Bank of Australia surprised markets by cutting the official cash rate to 2.75% earlier this month, and has indicated it still has “scope” to cut interest rates further, given our currently low rate of inflation and likely below-trend pace of economic growth this year.

Confirmation in the May Budget by the Gillard Government that they won’t be able to achieve a budget surplus this year – in fact, the deficit over the next two years will be higher than markets expected – has also raised international question marks over our reputation for sound fiscal management.

Continued concerns over the Chinese economy and the drop back in spot iron ore have also helped. Indeed, as I argued some weeks ago, seasonal trends suggest iron ore prices could weaken over the coming quarter at least, which should further undermine strength in the Aussie. Either way, iron ore prices are clearly past their peak, with both the Treasury and RBA predicting further weakness in prices over the next few years due to slowing Chinese demand and expansion in global iron ore supply.

Last but not least, the US economy continues to improve, which has increased speculation the Fed Reserve will ease its monetary stimulus – which has lifted the US dollar at the expense of other currencies such as the Aussie.

Good news for some sectors

If the $A is heading lower, it will be goods news for many trade-exposed sectors of the economy struggling under the weight of the high currency – not least of which is the mining sector.

Indeed, if the Aussie suffers a decent fall, it would have profound implications across the economy. Investors should note that it would help breathe life into the earnings outlook for the Australian equity market overall – given it’s top heavy with exporters rather than importers – as a falling $A boosts the $A value of profits earned overseas.

By improving competitiveness, it would also help revive still depressed business sentiment in the manufacturing, tourism and educational export sectors. And it might cause miners to think twice before mothballing more expansion projects.

On the downside, however, a weaker $A means the RBA would be less inclined to cut interest rates again this year – which would be less supportive for the housing sector. And a particularly large fall in the Australian dollar could boost the price of imported household goods, unnerve consumer sentiment and dent consumer spending – which would not be especially great news for the consumer discretionary sector.

In short, a lower $A – provided the fall is not too far too fast – should be of net economic benefit and positive for the share market, and tend to favour the mining and industrial sectors over financials, housing and retailing.

Fall has its limits

That said, it’s unlikely the $A will drop too far in a hurry – and it may well disappoint those hoping for a major boost to competitiveness. After all, even if the RBA cuts interest rates again – to 2.5% – they will still be attractive for foreign investors compared to the near-zero rates in most other developed regions such as Europe, Japan and the United States.

And despite the recent budget deficit blowout, net public debt is still very low by international standards, suggesting we’re still a good credit risk. Iron ore prices could weaken further this year, but possibly hold above the lows of last year, as China steel producers learn to better manage their inventory cycle and less efficient Chinese iron ore producers exit the market.

Last but not least, despite recent heightened fears, the US Federal Reserve seems unlikely to announce a scaling back of its stimulus program anytime soon, as it still regards America’s economic recovery as too fragile – particularly given the sharp automatic tightening in US fiscal policy in recent months. Similarly, Japan has announced a massive new money printing campaign, some of which will find its way into high-yielding Australian dollars.

All up, while days of the $A trading above parity to the US dollar may be over, it might hold itself above US90c over the coming six months or so at least – which might not be enough of an adjustment to prevent the RBA from cutting interest rates a little further.

The big move in the $A may come when (and if) the US Federal Reserve finally begins to tighten monetary policy and raise interest rates – which is still at least six months to two years away. For investors though, the “risk/reward” play says to stay ‘unhedged’ with your offshore investments – including global equity funds.

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 regards to your circumstances.

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