The Australian dollar has had an amazing run over the last five years. As the only major economy to escape a recession in the global financial crisis, Australia has become a safe haven for investors looking to escape the economic volatility and low interest rates of other developed economies.
Australia suffered its last major recession in 1991. Students graduating from Australian universities this year have never known a recession.
The result of this multi-decade period of economic growth has meant the Australian dollar is one of the strongest currencies in the world.
The strength of this strong currency no longer makes sense.
The economy is overloaded with debt, its indigenous sector is uncompetitive, its property prices are outrageous and its banks are heavily dependent on fickle foreign financing. The commodity sector that has underpinned the economy is recent years is slowing markedly, as a response to the recent fall in resource prices and the longer-term structural slowdown of the Chinese economy.
Australia is suffering from a classic "Dutch Disease" economy. This is where the non-commodity sectors of the economy get crowded out by the resource industry and become uneconomical due to high costs and a very strong currency. This can be seen in the Australian dollar's strength over the last few years. It has been above parity against the U.S. dollar since last summer.
To make matters worse the domestic economy is suffering from the largest intact housing bubble in the developed world and consumers who are laden with huge levels of debt. This property market has slowed recently and the bubble could be getting ready to burst.
All of the four main domestic Australian banks are systemic and are heavily reliant on foreign funding for their ongoing activities. This can dry up very quickly as the world experienced back in 2007 when credit in the interbank market disappeared overnight. If this were to happen the Reserve Bank of Australia (NYSE:RBA) would be forced to step in if any of these get into difficulty if /when the property bubble bursts. All four of Australia's main banks are too big to fail.
Over the very long term Australia has a bright future. It has a positive demographic structure, massive amounts of important commodities and the world's largest markets on its door step.
Unfortunately before this the economy badly needs to rebalance and shed the excessive debt and uncompetitive costs of the last decade. Luckily for Australia this process does not have to happen through the horrendous internal devaluation being forced on Greece, Ireland and Portugal. Australia still has control of its own currency. It can print as much currency as it likes to prop up its banks. It can engage in massive quantitative easing or liquidity operations to make the economy competitive again. Of course all of this will force the Australian dollar down and mean a far weaker currency.
Indeed the RBA has already begun this process with its recent series of interest rate reductions. This process will continue later this year and is already being felt as the AUD retreats against recent highs versus the U.S. dollar.
Significantly the Australian dollar has recently fallen back markedly against the euro - hardly a paradigm of financial stability. The long-term EUR AUD is 1.70. Currency the exchange rate is about 1.26. The AUD has a very long way to fall to get back to its historical trend average. Goldman Sachs (NYSE:GS) recently called this EURAUD trade "the trade of the century."
While a substantial weakening of the Australian dollar may not happen immediately, this process is likely to begin later this year. The Australian economy needs a far weaker currency if it is to regain competitiveness in its non-commodity, services and manufacturing economy. The RBA understands this and is adjusting down Australian interest rates accordingly. The challenge it faces is a potential very hard landing from the slowing property sector.
The wildcard in all of this is the banks. If they lose access to foreign funding the house of cards could come down quickly and force the RBA to step in and backstop the banks.
It is all very reminiscent of Ireland a few years ago before the economy stalled, the property bubble burst and the banking sector collapsed.
Either way the reasons for a strong Australian currency no longer make sense in light of weakening commodity prices and the tepid strength of economic recovery in the United States and China.
Traditionally the Australian dollar has moved in tandem with gold. The recent softness in the gold price will likely feed into AUD fairly soon.
The medium- to long-term investor should be looking to short the Australian dollar.