Coming face to face with a distant relative
20 October 2010
Sean Russo
OCTOBER 13: LOOKING back over past issues of this column and others, and a range of strategy notes to clients of Noah’s Rule over the past six years, there has been one theme that has been by far the most consistent. And that is the simple position that it’s not rational or logical to expect the Australian dollar to remain the Pacific Peso, adding healthy premiums to USD commodity prices if you are either in the crowd that has stapled itself to an ever expanding China; cemented yourself into a BRIC wall; you are in the crowd that believes the USD is going to hell in a hand basket; or, some combination of the three.
The titles have been things like, ‘Do gold bulls need to be Aussie bulls?’, ‘The Aussie dollar giveth and the Aussie dollar taketh away’, ‘Straw hats in winter’, and other variations on the same recurring theme as the AUD inexorably wended its way higher and the vast majority of pundits, it seemed, believed anything above the long term average of the mid 70s was an accident waiting to happen.
To be clear I took the easy out and didn’t say it would happen because I didn’t know what was going to happen to the BRICs and I don’t know what’s going to happen to the USD. I still don’t and I don’t trust anyone who thinks they do. Educated guesses and scenario analysis are essential to risk management but in my experience deeply held views or convictions can put their holder at the bottom of a very deep hole of their own digging.
My simple and consistent position has been that there is, and there should remain, a strong and long term correlation between commodity prices (and in particular metals and bulks) and the AUD/USD. There are leads and lags but the correlation is there and it shouldn’t be surprising.
Each boat (or plane full of gold bullion and coins) that goes north is sold in USD, essentially our miners dig USD out of the ground. If the USD prices of commodities are going up and as a consequence of higher prices the volumes of those commodities being shipped is also increasing, then the number of USD to be sold each week to buy AUD is increasing. Unless the supply of AUD is growing as fast as the supply of USD in circulation it stands to reason the relative value of an AUD must go up.
With a relatively finite number of AUD in circulation the owners of those dollars don’t stand in the market ignorant of all that demand and keep selling at the long term average. To entice them to part with sufficient AUD to bring those commodity proceeds home the sellers of those expanding balances of USD need to share the love. Ultimately they have to entice AUD based investors to switch to USD because otherwise it’s them against the BMW drivers and the “Must Have a 3D TV/iPad/Whatever, Now” crowd.
The owners of AUD cash deposits are earning some of the highest interest rates in the world; the owners of Australian equities are in the main (let’s ignore Telstra and a few others) being relatively well rewarded for hanging around in some of the relatively best run banks in the world and mining companies that are some of the biggest beneficiaries of the BRICs; and, the owners of Australian residential property continue to be rewarded for holding on, even if relatively their properties are now some of the most expensive in the world and have probably never been so expensive relative to what they can sell their services for in both local and foreign labour markets.
When my 11-year-old son was born, gold sold for $US293/oz and $A466/oz. Before his third birthday gold had fallen to $US250/oz and risen to $A530/oz as the Aussie dollar fell under 0.50. Last week in the shadow of his 12th birthday (which is determined by that period when serious negotiation starts on the party theme and venue) you had to look twice at the Bloomberg screen to tell the AUD gold price of 1377 from the USD gold price of 1364, a mere 13-dollar difference.
It’s painful for local producers to watch but the reality is even if AUD/USD were to go to 1.20 and USD gold were to hold at the current level of $US1350/oz a local gold price of $A1125/oz is not to be sneezed at and gold production would continue. We are still better off than we were with gold at $A466/oz. Do similar calculations for copper, nickel, iron ore, coal, etc and you will see the resulting AUD price is still sensational by any realistic measure.
I restate my simple thesis: if you are bullish commodities it makes no sense not to be bullish the AUD. Breaking 80c for the AUD/USD was like gold breaking $US500/oz. It had been done before but few could remember it well. In that sense, the AUD/USD breaking parity is rather like gold breaking $US850/oz – the level has a mythical significance, but really as we saw in gold, it’s just a number.
Will parity give way soon? Who knows, but don’t believe it can’t happen and don’t think that once it breaks it won’t create an enormous wave of anxiety among all those companies exposed to a higher Aussie that remain in denial. I believe when it breaks it could run to 1.1 or higher in a matter of weeks as large corporates scramble to cover. When the Canadian dollar broke parity in late 2007 it ran to 1.1 in seven weeks and then collapsed. I suspect the frenzy was their corporate treasurers who didn’t think it could happen similarly “biting the bullet”.
If you are a metal producer please don’t go out and fix your Aussie forwards and leave the metal unhedged; that’s called “doing a Pasminco” and it comes with significant risk. Buying calls on the AUD is the way to go and while most punters will tell you they are too expensive, I will tell you they are cheap relative to your risk reward profile without them and very cheap relative to the possible consequences of “doing a Pasminco”.
All that said I do think parity’s going to be a tough nut to crack. While our equity market is up 50% from the lows in 2009 in local currency terms an unhedged USD investor in this market is up over 100%. It’s not hard to see them very happy sellers of both our equities and our dollar at these kinds of levels. Equally with copper cresting all time highs, nickel back in the stratosphere and tin half way to the moon it might just be that we are due for them to take a bit of a breather which would reduce the immediate pressure, but even if prices subside (but don’t collapse) volumes will continue to grow and the pressure will build again.
Looking back at the break of the significant psychological 79/80c level, the market tested it 19 times in four years before it gave way and then ran 15c in six months. While it’s not a certainty Aussie will break parity anytime soon please don’t imagine it can’t, please recognise there will likely be a great deal of uncertainty and anxiety if it does and remember the next big milestone is 2.00 once 1.00 is below us!
Remember there are no absolutes when it comes to currencies, everything is relative.