Aussie Disconnected From Commodity Prices

Australia | Jun 18 2019

ANZ Bank economists note the Aussie dollar is no longer being supported by commodity prices as has typically been the case.

-Iron ore up, Aussie down
-Mining profits up, economy weak
-Chinese stimulus no longer supportive

By Greg Peel

The Australian dollar has long been considered a “commodity currency” given Australia’s major exports, and thus source of income, are minerals, metals and gas. But as the Aussie slides below US70c at a time iron ore prices have shot up over US$100/t, ANZ Bank economists suggest that at least for now, that connection no longer holds true.

Typically, stronger commodity prices incentivise greater mining investment and lead to increased mining profits, which then flow through to increased tax collections for the government.

Greater mining investment means more jobs, increased profits mean greater returns for investors who can then spend that money, driving economic growth, and increased tax collections allow for increased government spending, also driving economic growth.

More jobs and profits lead to wage & price inflation, and between stronger growth and rising inflation the RBA is forced to raise interest rates. Before this flow-through occurs, the Aussie will have already risen in anticipation.

But the RBA has just cut its cash rate to a new historic low with more cuts expected and the Aussie continues to fall.

The reasons behind this disconnect are several, ANZ Bank economists suggest.

Firstly, as the last of the big LNG plants complete construction, the mining investment boom enjoyed by Australia over the past decade is coming to a close. While miners are making solid profits there is little incentive to invest in further growth. We’ve seen the growth phase, now we’re in the production phase.

Instead of investing in further growth, miners are returning most of their profits to shareholders via dividends. While such money in the pocket should lead to increased consumer spending, the reality is 50% of Australian stock market investment is held in super funds, which is money that can’t yet be spent.

The government may well be enjoying greater tax receipts from the miners, except a lot of recently constructed mining (and gas) projects are foreign-owned. And the government is hell bent on returning the budget to surplus, which keeps a lid on government spending.

As the recent federal election result highlighted, a lot of mining jobs have been lost since the investment phase gave way to the production phase which has led to high unemployment and electorate desperation in, particularly, northern Queensland. The RBA is now fixated on lowering the unemployment rate from over 5% to 4.5% in order to lift wage growth and thus inflation, hence the recent rate cut.

ANZ Bank is not alone in believing this is a tough ask, even if the RBA cuts three times all up, the government delivers its tax cuts and the Aussie falls to US65c.

While the iron ore price initially shot up this year due to Brazilian export suspensions, more generally commodity prices are determined by demand from Australia’s biggest trading partner – China. When the Chinese government decides to implement economic stimulus, which typically includes investment in infrastructure, a subsequent increase in commodity demand pushes up prices.

In other words, the Aussie should go up every time Beijing ups the stimulus ante. But that’s what’s happening now, and there’s talk of more to come, yet the Aussie has slipped under US70c for the first time since the GFC.

With this direct correlation now broken, ANZ Bank suggests increased Chinese stimulus can still provide for flow-through improvement in the Australian economy if it drives an increase in risk appetite. But on that front we have to look at why Beijing sees the need for stimulus. The Chinese economy is slowing.

Indeed, the global economy is slowing. It is not a time of increased risk appetite.

Of course, a lower Aussie is a matter of swings and roundabouts for the Australian economy. Once upon a time an Aussie in the mid-to-high sixties was considered “just right”. Exporters benefit from a lower exchange rate – not just in the resource sectors, but in the likes of tourism and the burgeoning foreign education sector.

On the flipside, not a lot of products are manufactured in Australia any more. Not even cars. And there is more and more imported food on supermarket shelves. Consumers are the losers at the checkout when the exchange rate falls.

So it’s a balance. And arguably one of the primary reasons the Australian stock market has well-underperformed Wall Street post-GFC is because the Aussie ran up from its GFC low to over parity with the US dollar in 2012, and taken this long to come back down again.

That had the RBA very frustrated at the time. While the central bank is hardly without its worries at present, the fact higher commodity prices (iron ore in particular) are not ultimately leading to a stronger currency at this time must be a blessed relief when monetary policy capacity is swiftly running out.

Which is not an issue for the Fed. The US central bank is widely tipped to cut rates soon which, ceteris paribus, should lead to a weaker US dollar and thus a stronger Aussie dollar. UBS economists, who agree with ANZ Bank's assessment of the Aussie disconnect with commodity prices, suggest in a world bracing for a trade war and resultant further slowing in global growth, the Aussie is not likely to find such support.

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