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Falling inflation expectations a game-changer for the Australian dollar

The Australian dollar, once the darling of currency investors, has fallen firmly out of favour, with the pace of the move taking many by surprise.

While a drop in yield support and worries over mining investment plans can explain some of the weakness in the currency, declining global inflation expectations appear to have destroyed a main source of support and could be a game-changer for the Aussie.

Having dropped out of the $1.02 to $1.06 range that had held since July after the Reserve Bank of Australia (RBA) cut rates earlier this month, AUDUSD has broken down through parity and is now threatening to hit an 11-month low below $0.97.

Indeed, the price action this week – AUDUSD has tumbled nearly 3% – suggests that longer-term, real-money investors have been bailing out of long positions in the Aussie dollar after its move down through parity. That would seem to be supported by client flow data, with UBS reporting that selling of the Aussie dollar by asset managers was the second highest on record last week. 

AUDUSD approaches 11-month low 

The sell-off in AUDUSD has come as the dollar has rallied across the board, as better US economic data have raised expectations that the Federal Reserve will scale back its quantitative easing (QE) programme.

Still, while the dollar has rallied broadly, the Australian dollar has moved sharply lower against a range of currencies, suggesting there are other factors that are weighing on the Australian unit rather than just Fed policy expectations.

The RBA’s move to cut rates is one of those factors. However, even after the central bank’s decision to cut rates by 25 basis points to 2.75% at its May meeting, Australia still has the highest benchmark interest rate among advanced economies.

Others point to the postponement of mining investment projects as another factor that has undermined the Aussie dollar, raising concerns, as it does, that the sector’s investment boom has peaked.

The massive capital expenditure undertaken in Australia’s resource sector during the past few years has, after all, provided a huge boost to the economy. As the chart below shows, total annual investment has increased from around A$100 billion five years ago to an estimated A$170 billion in the current financial year, a positive shock that is estimated to contribute between 1% and 1.5% to Australian GDP. 

Australian total capital expenditure 

However, that positive shock to the Australian economy is receding, with the Australian Bureau of Statistics’ last capital expenditure report estimating that total investment in the next financial year, 2013-2014, will be A$150 billion. The next update of Australia’s capital expenditure report comes on May 30.

Clearly, if that figure were to be revised lower, it would provide a headwind for the Aussie dollar, raising fears that the country’s mining boom is ending more rapidly than anticipated and putting pressure on the RBA to further cut rates to boost the growth in the rest of the economy.

However, Andrew Salter, FX strategist at ANZ, points out that while both declining interest rates and mining investment concerns are legitimate explanations for the recent sell-off in the Aussie dollar, they do not explain the speed of the move.

“Interest rates have been declining for some time, while it has long been known that mining investment will peak gradually this year,” he says.

Salter believes the missing link that explains the sudden sell-off in the Aussie dollar can be found in the reassessment of global inflationary expectations that has been occurring in the past few weeks.

That shift can be seen in the sharp decline in gold prices in April, and the weakness witnessed recently in other metals prices such as silver and copper.

The change has been driven by the lack of realized price pressure in large developed economies, with central banks being largely successful in keeping inflation in check despite the massive increase in global money supply generated by their ultra-loose monetary policy stances.

Investors that had positioned for a break higher in global inflation on the basis of aggressive central bank easing have, according to Salter, now thrown in the towel after years of waiting.

“The data simply do not corroborate their fears,” he says.  

 Core measures of inflation under control

That is important for the Australian dollar, since one of the primary channels through which it has benefited from the QE undertaken by the world’s largest central banks has been as a result of higher commodity prices, which have been driven higher as investors have hedged against a break-out in inflation.

The Australian dollar has, in other words, been a hedge against global inflation for some time due to Australia’s trade exposure to commodity prices. That, however, is changing.

“Commodities are no longer recipients of investor demand based solely around inflation protection,” says Salter. “This change is the missing link in the recent fall in the Australian dollar.”

The effect can be seen in the breakdown in the correlation between the Aussie dollar and US equity prices. QE from large central banks now benefits equities and bond prices more than commodity prices, which in part are a hedge against inflation.

Accordingly, the correlation between AUDUSD and US equities, which stands at 0.73 over the last five years, has fallen to 0.32 since the middle of April.

Clearly, QE from large central banks can still boost the Aussie dollar by raising expectations for global growth and enhancing the currency’s yield advantage.

However, with the link between QE and higher commodity prices seemingly severed, any bounce in the Australian dollar due to further monetary expansion from the world’s largest central banks is likely to be smaller.

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