Why a Higher Aussie Dollar is The Boost Aussie Stocks Are Waiting For

It seems so long ago.

And yet it wasn’t.

It was only about two months ago that it was falling.

Most people said it would go even lower.

But since then things have turned. And now, maybe there’s a chance it will go higher again.

And if it does it could be the extra boost that Aussie stocks have waited for…

What is the ‘it’ we’re talking about?

It’s the Aussie dollar of course.

The Aussie dollar stayed above or near par with the US dollar from late 2010 through until the end of May this year.

It stayed high not because anyone expressed any particular confidence in the Aussie dollar, but because Australia had higher interest rates than the US.

This allowed investors to take advantage of the carry trade. That means borrowing in a low interest rate currency (US dollar) and then converting the borrowed dollars into a higher interest rate currency (Aussie dollar).

For the big institutional investors this can be almost a risk-free trade…providing economic conditions are stable and predictable. Although it may not have seemed like it at the time, the period from late 2010 to mid-2013 was relatively stable…in a way.

It was stable in that almost everyone knew that the US Federal Reserve would keep printing money. As long as investors kept thinking that, the carry trade would continue.

That all changed this past May…

Death of the Carry Trade

The following chart shows the vicious sell-off in the Australian dollar that started in May and continued through until the end of August:


Source: Google Finance

If you recall, May was around the time when the markets began to get the jitters about a possible end to the US Fed’s money printing.

The argument went that if the Fed stopped printing money it would cause US interest rates to rise, which would result in the US dollar rising against other currencies.

That was the last thing the carry traders wanted to hear. Even the potential for the money printing to end was enough. Carry traders dumped the Aussie dollar in droves in order to return to the perceived ‘safety’ of the US dollar.

The result was the chart you see above.

(Note: Because the carry trade involves borrowing US dollars and buying Aussie dollars, if the Aussie dollar falls traders have to use more Aussie dollars to pay back the US dollar loan.)

The Bull Market Keeps Going

The natural reaction by many was to assume that not only would this exodus from the Aussie dollar see the Aussie dollar fall, but that it would cause stocks to fall too.

This view was right…for a brief time anyway. But around that time we suggested you should take that conventional wisdom with a grain of salt. We argued that a falling Aussie dollar could just as likely be good news for Australian stocks.

It was part of why we said investors shouldn’t sell stocks even though most other folks had panicked and sold. As the following chart shows, we looked pretty dumb at first, until stocks started to turn back up again in June:



Source: Google Finance

The S&P/ASX 200 index is the red line. You can see that after the panic selling stopped in June, the Aussie market rallied around 10% even though the Aussie dollar stayed mostly flat.

But now things have changed again. The market has at last come around to our way of thinking, and it looks like being more good news for Aussie stocks…

Resurrection of the Carry Trade

It would be natural for you to think that if the Australian stock market went up as the Aussie dollar stayed low, then won’t it be bad news for Aussie stocks if the Aussie dollar goes back up again?

The answer is no. Now before you accuse us of being a perma-bull, where we only ever see good news for stocks whatever the prevailing news, let us explain our view.

Our view is that the market has finally gotten it. After months of being duped into thinking the US Fed was about to stop money printing, the market finally realises there is zero chance of that happening.

So that now the market realises there is only one outcome – more money printing, a continuation of low interest rates, and investors buying risky assets.

Whether you agree or disagree with this from a moral or macro-economic view, it doesn’t matter. What matters is what will happen to stock prices. The US Congress has delayed any action on the budget and debt ceiling until next year, and new Fed chairman Dr Janet L Yellen starts in her new job around the same time.

Seeing the instability that the Fed, the US president and the US Congress have created over the past five months, the protagonists will be keen to avoid repeating this mess. As we say, that means more of the same.

And from an Aussie perspective it should mean more good news for stocks as the carry traders regain their confidence and look to benefit from Australia’s relatively high interest rates compared to the US.

The next surge in stock prices may not happen overnight. But last night’s action in the US is a pretty good start. The US S&P 500 index stands at a new record high.

This means Christmas may come early for investors. Look out for the ‘traditional’ Christmas rally. If it kicks off as much as we expect, that should mean the Aussie index hitting our short-term target of 6,000 points by the end of the year.

Cheers,
Kris+

From the Port Phillip Publishing Library

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read. Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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