Press release - 30th October 2008
Australian dollar volatility: an explanation
In the last few days we have seen the Aussie dollar continue to
tumble. Today it has "settled" around US60 cents having been
around 67¢ at the end of last week. Part of that settling process was
due to the Reserve Bank intervening in the market as a buyer. The
most important driver of the Aussie dollar now is the de-leveraging
of large Aussie positions by global speculators. (De-leveraging is the
process of debt reduction by asset liquidation. When undertaken by
a financial institution, this is a violent process, as liabilities usually
exceed assets by much more than in a non-financial business). These
speculative investors are dominated by the hedge funds but will also
include Japanese retail investors, US and European mutual funds and
investment banks. The hedge funds, which are not subject to the
same regulatory disciplines as the banking system, have been able
to gear at up to 40 times their funds under management or more.
Hedge funds manage just under $US2 trillion of investor's money -
but considerably more when gearing levels are taken account of.
The common speculative trade was to borrow in USD or particularly
the Japanese yen at very low rates and buy assets in high yielding
currencies such as the Australian dollar and the New Zealand
dollar, plus in many emerging markets like South Africa and Brazil.
They were also large investors in commodities - riding the wave
of optimism associated with the Chinese "miracle" and of course
enhancing their own profits with the momentum of new buying.
When they started to get squeezed in the early stages of the credit
crisis they initially sold another very liquid investment in the form of
US shares, especially bank shares, which were the obvious target in
the early stages of the crisis.
Since about mid July, when restrictions were applied to short selling
bank shares, these funds have concentrated on de-leveraging by
selling their holdings of commodities, resources stocks and high
yielding currencies. Hedge fund performance has been poor and
investors are lodging redemption notices. That is accelerating their
need to raise US dollars. Because the banks who fund them now
apply strict gearing limits releasing cash for redemptions requires a
full de-leveraging of their gearing. There is no way of knowing how
far through the process of these funds have gone but it would take a
very brave person to assume that we are at the end.
That means that we will probably have to endure a longer period of
huge volatility and potentially further weakness in the AUD. When
the de-leveraging process has stabilised there are good arguments
to see value in the AUD. For example, the last time the AUD was at
60¢ (back in April 2003) Westpac's Commodity Price Index was at
100 - it now stands at 180 having fallen 44% from its peak around
mid July this year. Part of the reason for this precipitous fall has been
the selling of commodities as a part of the de-leveraging process.
The last time the AUD was at 60¢ Australian cash interest rates
were at 4.75% while US rates were at 1.25% - a gap of 3.5%. We
expect Australian rates to eventually fall from the current 6% to
around 4.5% by March next year while US rates are likely to fall to
0.5% from the current 1.5% over the next few months. So despite
an aggressive easing policy from the Australian authorities we are
still likely to enjoy a very comfortable margin over US rates.
Australia's flexibility to cut rates substantially - a total easing cycle
of 2.75% with ample scope to go even lower - emphasizes our
better growth prospects. Fiscal policy can also be used to ensure
that household incomes grow adequately despite a likely slowdown
in jobs growth. The Australian government has accumulated huge
surpluses in recent years ($67bn in the Future fund; $20bn in the
Building Fund; $10bn in the Health Fund and $5bn in the Education
Fund). Those funds can be used to accelerate infrastructure
spending plans which will now have more room to access resources
as the commercial construction boom slows down.
Finally the funding difficulties which the major banks encountered
will now be essentially fixed. The big problem was access to
offshore funding for Australian banks as the failure of Lehman
Brothers and Washington Mutual raised the spectre with investors
that any bank could go broke. (The failure of Lehmans accelerated
the hedge fund de-leveraging imperative directly, as Lehman was
"prime broker" for hundreds of funds.) Australia's four majors now
have an AAA government guarantee for a reasonably competitive
price which they can use to access a broad range of funds in
offshore markets. Funding costs will not return to the lows of the
pre crisis period but will be more attractive than recent months
when markets soured so quickly. I also think that the Australian
banking system has access to sufficient capital to allow it to assist
significantly with the refinancing of corporate loans as foreign banks
inevitably seek to take their capital back to home base.
In summary, for many customers trading the FX markets has
resembled taking a roller coaster ride in the dark. Unfortunately,
I am not able to provide assurance that the volatility is at an
end. Indeed, it is my advice that volatility will remain high for a
considerable period. With uncertainty at extremes, please utilise our
experienced financial markets team to assist you and your business
mitigate the impact of these difficult times.
Text by Bill Evans, Chief Economis - Westpac Institualional Bank
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