Friday, January 29, 2010

Australian dollar update

I post this to follow up on a question from a reader concerning the advisability of investing in Australia. The main risk I see is that everyone loves Australia right now, and that's why the currency is about as strong relative to the U.S. dollar as it has ever been. If you are a U.S. investor putting money to work in Australia today, the price of admission is very high. That's not to say the investment doesn't make sense, just that the relative value of the investment is not terribly attractive, and there is the potential for significant downside currency risk.

To explain the chart: the blue line is simply the Aussie dollar exchange rate, while the green line is what I calculate the purchasing power parity (PPP) of the exchange rate to be over time. The PPP calculation takes account of the differential in inflation between Australia and the U.S., and it is theoretically the value of the currency that would make a given basket of goods and services cost the same in both countries. With the blue line exceeding the green line by a wide margin, this means that a U.S. visitor to Australia is likely to find that most things are expensive relative to what they cost in the U.S.

The downtrend evident in the PPP line means that Australian inflation has tended to be higher than U.S. inflation, so the currency therefore has a tendency to trend lower over time against the dollar. This may of course change in the future, and that wouldn't be impossible at all, especially considering that the Aussie central bank has already tightened monetary policy but the Fed is many months away from doing so.


Rob said...

Hi Scott, I'd love to get your thoughts on the UK £ ..

Scott Grannis said...

I'm having trouble coming up with a decent opinion on sterling. According to my PPP calculations, sterling is about 12% overvalued relative to its PPP vis a vis the dollar. That's not much to get excited about. I do note that UK inflation has been higher than US inflation for a very long time, and that looks to be continuing. That would give one a bias to being short sterling, but again I wouldn't put much weight on that view. I would be hard-pressed to take a position one way or another.

Rob said...

Well that's still very helpful Scott, many thanks !

Rob said...

The reason I keep asking about Sterling, Scott, is that I keep coming across this sort of thing:

"Bill Gross, an astute American who runs the $200bn Pimco Total Return fund, that the UK is a must to avoid, with high debt levels and a finance-oriented economy. Reported by Citywire, he says our government securities, he says, are resting on a bed of nitroglycerine. High debt with the potential to devalue the currency present high risks for bond investors. So we need to be wary of fixed interest stocks, as well as equities."

It is very alarming as a UK resident with most of my assets in ££. When people talk about devaluing a currency I have no idea by how much that could be !

Rob said...

Scott, sorry to harp on about the £ but after today's news re. the UK's appalling public finances I am pretty desperate to know how vulnerable the £ is re. other currencies and esp. the $ .. As I write it is in another freefall period. Do you have any more views on it, eg do you see it going below 1.50 in the near future ? Many thanks for your help Scott.

Scott Grannis said...

Rob: I'm not one who believes that government finances, especially in a major industrialized economy, are the primary driver or even a significant driver of inflation or exchange rates.

The £ is vulnerable if UK monetary policy stays too easy for too long and UK inflation rises significantly as a result, and/or if the UK economy underperforms other major economies.

Inflation does look a bit on the high side, and big tax hikes in the UK have hurt growth prospects on the margin. Meanwhile the £ looks to still be above my estimate of its PPP (about 1.43). Also, the dollar is getting a bid these days, as the US economy looks to be outperforming Europe and the Fed may end up tightening sooner than people had expected.

I wouldn't be surprised therefore if £ lost more ground relative to the dollar, and falling below 1.50 would not be very difficult.

Rob said...

Many thanks again Scott, your insights are really valuable. I have decided to hedge some of my exposure to £ by s/betting on Cable.

Rob said...

Hi again Scott. I'm sorry to bug you again about Cable, but I'd be ever so grateful if you could answer 2 more questions please:

1. When you calculated £-$ at 1.43 do you feel confident about your methodology?

2. Since £ has been having a bit of a rally last 2 weeks, some chartists see a bullish signal. Do you set much store by such things?

I'll understand if you're too busy to answer !