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It's still the dollar!

Ron Bewley
17 August 2011

The ASX 200 has traded sideways for 18 months while the S&P 500 boomed and bust.

Our argument that we put forward in a January 2011 edition of Money Management and again on SWITZER on 2 March still holds. We are moving in lock-step with the US when we price both in the same currency! This strong relationship helps partly explain some of the movements in last week's market turmoil.

With the chance of a statement from the RBA of rates not going up – or even a little rate cut – could take our dollar firmly below parity.

When the markets recover, we might start to gain ground on the US.

This argument has nothing to do with two-speed, or patchwork, economies. It is a valuation problem. Foreigners view our market in their own currency.

The dollar

Since the start of 2010, our dollar against the US greenback has traded in a near 40 per cent range – see Chart 1. There is little disagreement – if any – that these movements are due to commodity prices and the expected interest rate differential between Australia and the US.

Importantly, it is the expectations – and not just the differential – that counts. The Reserve Bank of Australia (RBA) has run at least an implicit campaign that rates will rise this year since the last increase on Melbourne Cup Day 2010. This expectation arguably drove rates up through parity and as high as more than 110 US cents.

Chart 1: The Australian dollar

Source: Thomson Reuters Datastream

Even in July 2011, the consensus was for a rate rise or more. Westpac announced a forecast of a one per cent cut within a little more than a year. We wrote in Ron's Wrap 1 August on our website that this forecast was a bit over the top. A little 25bps cut would do the trick – even saying no rate rise would be a massive boost to confidence. Imagine you had just bought a house at, say, a variable rate of eight per cent and someone keeps telling you he is going to force rates up. Do you spend? Of course not, and we wonder why confidence and retail are struggling?

If the RBA said they were holding at 4.75 per cent, the differential wouldn't change, confidence would be up and the dollar would fall. Don't they get that?

The markets

Everyone knows the story that our market has range traded since at least January 2010. To compare our market with that in the US, I have rescaled the US data to start the period at the same point. They are only indexes – we can multiply by any number we want to so-call re-base them. I show them both on the same scale in Chart 2. S&P USD is the S&P 500 in US dollars rescaled to line up with the S&P/ASX 200 in Australian dollars – ASXAUD.

The story is clear and well known. They went up and fell; we went sideways and fell. Not fair. However, we are comparing apples and oranges. The ASX 200 is measured in Australian dollars. If we consider a fully-hedged position from the US, we need to convert Chart 2 to a common currency. Chart 3 is how a foreigner would see the problem. What is all the fuss – they are moving together – and in the same way we said more than six months ago! It is the same chart updated.

I can see a divergence around April - June 2010 when the mining tax debate drove our market down – we can now see the cost of that debate. Otherwise blow-for-blow – almost – the markets move in synch. Indeed, the massive volatility in markets for the week of 8-12 August didn't always get translated directly. We argued elsewhere on our website that the rapid fall in the Aussie cushioned our fall on two big days.

So where from here? If the RBA comes clean and our dollar starts to depreciate, we can start gaining ground on our own and against the US. We have our market underpriced by 15 per cent. Cheap markets can get cheaper – but this market is OK for me. We even have room for a five per cent catch-up against the S&P 500 on the dollar alone as at Saturday 13 August!

The two-speed economy impact would have some sectors - like retail and tourism - hurting but not others. The correspondence wouldn't be as close if that were the problem. Of course the dollar is hurting some businesses - but we will see that in the earnings in due course. What we see in Charts 2 and 3 is a day-by-day revaluation.

Chart 2: A comparison of the Australian and US markets in own currencies

Source: Thomson Reuters Datastream

Chart 3: A comparison of the Australian and US markets in same currency

Source: Thomson Reuters Datastream

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