The History of the Australian Dollar (Aussie)

In today’s article, we continue our series on the History of Currencies, with a particular focus on the popular carry-trade currency: the Australian Dollar. According to the BIS Foreign Exchange Turnover, the Aussie stands at the 5th position (straight after the British pound) in terms of volume with a daily average of 348 billion US Dollars (which represents 6.9% in percentage shares of average daily turnover).

This article is organized as follows. In the first section, we quickly introduce some important historical events for Australia and its currency. In section 2, we explain the trends and reversals of the Australian Dollar (versus. USD) since the end of the Bretton Woods system in addition to stating the main potential drivers of the currency pair. In Section 3, we quickly present a few [practical] charts using the Aussie for our case study.

I. Important events in Australia and the history of the Aussie until the end of the Bretton Wood System (1971)

A. Origins and History

From being the land of the indigenous Australians (60,000 years ago) to becoming a Federal Constitution on January 1st 1901, Australia attracted the interest of many conquerors. But the two main European explorers were the Dutch (Willem Janszoon, 1606) and the British (James Cook, 1770).

Despite the first European settlement taking pace in the late 1788 at Port Jackson in New South Wales (Sydney today), the latter colony experienced money shortage for the next three decades as the British [Empire] was challenged by France under Napoleon, investing large amounts of capital and resources to win. Hence, the mean of exchange (what today could be called ‘Store of Value’ or ‘Reserves’) during that period was Rum.

Then, the first coinage issuance happened in 1813, after Lachlan Macquarie (Governor of New South Wales) took the initiative of using 10,000 British pounds worth of Spanish Dollars received by the British government. The plan, that took a year to complete, was to convert the 40 thousand imported coins to 39,910 holey dollars (coins with a hole inside) and 39,910 dumps. Then, in 1817, the Bank of New South Wales (first bank in Australia) was established to provide economic stability for the citizens of the state, and started to issue paper currency.

Eventually, Sterling coinage was introduced in 1825 in all British colonies as a result of the Coinage Act 1816 (British Gold Standard) and the decline in the supply in Spanish dollars due to Latin American wars of independence, and the Holey dollar went out of circulation in the late 1820s (no longer legal tender in 1829). Due to a large increase in the population, and a rejection from Britain to the requests from Australian colonies to make gold coins, unofficial gold coins were used during the Victorian gold rush of the 1850s. Then, in 1855, Australia’s first official mint was established in Sydney, and started to produce gold coins called sovereigns (worth 1£), half sovereign and private bank notes.

B. Australian Pound, Gold Standard and WWI

After the Federation in 1901, Australia started to prepare for a national currency as the government started to realize the importance of a stable currency regime. Hence, in 1910, the Australian pound was born, consisting of 20 shillings. As the Australian pound was pegged to the British pound, Australia was therefore on a Gold Standard. If we look at the bilateral exchange rate against the US Dollar, we know from Figure 1 that the British Pound was roughly worth 5 units of USD, hence the USD/AUD exchange rate at that time was fixed at $5.

In 1914, Britain temporally exited from the Gold Standard as a consequence of WWI, creating inflation pressures, but returned to it in 1925 at the parity. As the exchange rates (both the British and Australian Pound) devaluated during and after the War, the sharp revaluation of the two currencies reduced exports drastically and raised deflationary waves resulting in both an increase in the unemployment rate and a contraction in productivity (See Australia Terms of Trade history in Figure 2 (Gillitzer and Kearns, 2005)).

Australia left the Gold Standard in 1929 due to the Great Depression and started a series of devaluation against the Sterling pound. All we know is that in December 1931, a Sterling pound was then worth 1.5 Australian pound. Between 1929 and 1932, the sharp contraction of the terms of trade as a result of a fall in commodity prices severely impacted the Australian economy. The unemployment rate soared to over 20 percent in the early 1930s (Figure 4), leaving hundreds of thousands of Australians out of work, and the country’s national income declined by 30 percent.

The devaluation of the currency and the improvement of major trading partners’ economies (United Kingdom and US) led to a slow recovery, with improvement in the Balance of Payment and an unemployment rate slowly converging to its long-term mean (5 percent) thanks to an explosion in the manufacturing sector.

C. World War II and Bretton Woods period

As we described in our article History of the British Pound, an agreement between the US and UK pegged the Sterling pound to the US Dollar at a rate of $4.03 in 1940. That exchange rate remained fixed after the start of Bretton Woods agreement in 1944, but UK Chancellor of the Exchequer Sir Stafford Cripps announced a 30-percent devaluation from $4.03 to $2.80 in September 1949. At the same time, Australian Prime Minister Ben Chifley followed the British move and devalued the Australian pound from $3.224 to $2.24 in order to not experience an over-valued currency relative to its Sterling zone countries. That means during all that period (before and after the devaluation), the Australian pound was worth 1.25 per unit of Sterling pound.

D. The Birth of the Australian Dollar (and the RBA)

After several names suggestions for the currency (i.e. royal, austral, koala, digger…), the Australian pound was eventually replaced by the Australian Dollar in 1966 (February 14th), almost 6 years after the establishment of the Reserve Bank of Australia (i.e. Australia’s current central bank). The rate of conversion was set at two [Australian] dollars per unit of Australian pound, which means that the Australian Dollar was worth US $1.12. The UK government of Wilson announcement of a 14-percent Sterling depreciation against the US Dollar (from $2.80 to $2.40, see figure 1) didn’t impact the Australian Dollar, which rate remained pegged to the US Dollar at a rate of $1.12.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon Shock and the Smithsonian Agreements (1971 – 1973)

After the Nixon Shock in August 1971, the Australian Dollar was revalued several times against the US Dollar, from its starting point at $1.12 to a historical high of $1.488 in 1974. Unlike many countries that decided to let their currency float at the end of the Smithsonian Agreements in February 1973, Australia tried to keep its exchange rate fixed (against the greenback).

B. 1974 – 1986: A Decade of Depreciation

The deterioration of the terms of trade in the mid-1970s (See Figure 2), coming from a change in economic circumstances in addition to a strong exchange rate (even versus booming economies such as Japan and Germany), led to a series of exchange rate devaluations. The first one occurred in September 1974, when the Australian Dollar was devalued by 12 percent to $1.31. The second one happened in November 1976 when the Government decided to devalue the currency by 17.5 percent, and the Aussie reached a low of $1.0160 after that announcement. The pair consolidated in the late 1970s and early 1980s to reach a high of $1.19 in January 1981, thanks to an investment boom in 1980 and 1981 following the 2nd oil shock in 1979. However, the recession that hit most the OECD countries in the early 1980s (due to the Oil Shock) reduced drastically the demand for Australia’s minerals and energy, and the inflationary pressures generated by the wage explosion of 1981-1982, both led to a perception that the Australian Dollar was starting to be overvalued. The Australian Dollar then started a two-year depreciation against the greenback, and ended its fixed regime area by a 10 percent devaluation in March 1983, when PM Bob Hawke came to power and announcement the third big depreciation in hope of spurring the export sector.

C. 12 December 1983: From a Crawling Peg to a Floating Regime

In March 1983, one unit of Australian Dollar was worth roughly 85 cents of US Dollar. The exchange rate again consolidated until the end of the year and in December 1983, the Aussie Dollar was floated and foreign exchange controls were dismantled [during the night on December 12].

In the last few years before moving to a floating regime, the Australian Dollar was pegged to the Trade Weight Index (see computation of the TWI Index in Table 1) and the value of the exchange rate was determined each day by the RBA in consultation with the government. The reason of the float move was mainly to improve the efficiency of the financial system, in addition to providing the authorities better control over domestic monetary policy (Blundell-Wignall et al., 1993).

The change in the policy resulted in a sharp appreciation of the volatility of the Australian Dollar [both bilateral exchange rate and TWI], adding pressure on the commodity currency. The exchange rate experienced significant losses against the US Dollar, reaching a low of $0.5960 in August 1986.

D. 1986 – 1989: The Aussie Strength

When it comes to Australia, the terms of trade has always been one of the fundamental drivers of the exchange rate, which is strongly correlated to commodity prices. As a result of a 50 percent increase in commodity prices between 1986 and 1989 (due to a strong increase in the world’s demand), Australia terms of trade increased from 52 in Q3 1987 to 63 in Q3 1989, hence pushing up the exchange rate USD/AUD from $0.5960 to $0.8960. During that period, Australia was experiencing an investment ‘boom’, a strong business confidence and rising national savings. Concerned about the sustainability of this economic ‘boom’ and RBA policymakers started to run a tightening monetary policy as a response to ‘deflate’ the asset price inflation wave.

E. 1990s: Weak global demand, low commodity prices and the Aussie depreciation

The US recession in the early 1990s, Japan’s beginning of the deflationary deleveraging decade in addition to the 1990s Financial Crises in Nordic Countries have decelerated global demand, impacting commodity prices and therefore shrinking Australia’s term of Trade. According to the Bloomberg Commodity Index (BCOM), commodity prices fell 42 percent between Q2 1997 and Q2 1999 (chart 2). During that same period, the Aussie depreciated by roughly 20 cents against the US Dollar, dropping from $0.80 to $0.60.

F. 1998 – 2002: The Dollar appreciation (Aussie Weakness)

As we discussed in our previous articles on FX history, the turn of the millennium was expressed by a US Dollar strength against the major currencies (we saw it with the Euro, Sterling pound and the Yen). The second part of the 1990s was characterized by the famous Clinton Dollar rally, where the USD index increased from 80 in early 1995 to 120 in early 2002 on the back of significant productivity gains, budget surpluses and capital inflows in the equity market (and especially tech stocks).

During that period, USD/AUD went down from $0.65 to hit a historical low of $0.48 in late 2001.

 G. 2002 – 2008: Global Demand and Super Cycle

The emergence of China (and other emerging market economies known as the BRICs) at the turn of the millennium led to a sharp unanticipated increase in commodity prices (see chart 2, Super Cycle), with the BCOM Index rising from the low 90s in early 2002 to almost 240 in July 2008, which resulted in a levitation of all commodity currencies. The Australian Dollar increased from its record low of $0.48 to $0.9850, more than doubling its value during those 6 years. If we look at the chart of the USD/AUD overlaid with the BCOM index (chart 2), we clearly an important correlation between the currency pair and commodity prices.

In a recent publication, Ferraro, Rogoff and Rossi (2015) showed that there exists a relationship between changes in the price of a country’s major commodity export price and changes in the nominal bilateral exchange rate for short frequency time series (daily data).

During that period, investors were also chasing the carry trade strategy, one of the most popular strategy in FX, where a typical trade would involve borrowing the currency with the lowest interest rate (such as the Japanese Yen) and investing in the currency with the highest interest rate (i.e. Australian or New Zealand Dollar).

H. July – December 2008: Risk-Off, Carry Unwinds and Aussie Crash

In the second semester of 2008, the Aussie experienced significant depreciations against the safe-heaven currencies, such as the US Dollar, the Japanese Yen and the Euro. For instance, between July and October 2008, USD/AUD went plummeted from $0.985 to 60 cents ($); more surprisingly, the Aussie depreciated almost 50 percent against the Yen, JPY/AUD went down from 104.50 to 55 during the same period.

We will talk more about the potential explanations behind the crash in our case study (Section 3), but one important thing to understand is that investors typically look at the Aussie as a risk-on asset and the currency tends to be highly correlated with equities in general. Hence, when economies plunge into recessions, equities typically fall, and so the Aussie (Chart 4).

I. 2009 – 2013: Commodity recovery and an overvalued Aussie

In reaction to the Financial Crisis, central banks lowered their interest rates down to record levels (zero bounds) and started a series of outstanding purchases of assets (QE). The recovery was immediate in commodity prices (Oil surged from 40 in 2009 to over 110 in 2011), which was one of the key drivers of the Aussie strength during that period. Note that Australia is perceived as an export driven economy: according to the World Bank, it exports totalled $190bn in 2015, with Iron Ore ($37.5bn) and Coal ($30.2bn) being the top-2 earners, with China ($62.3bn) and Japan ($$30.7bn) accounting for roughly 50 percent of the exports (see Picture 1).

Australia is also the beneficiary of a ‘double Chinese dividend’. In addition to export goods and commodities to the giant China, the shiny coasts are trending destinations for Chinese tourists. Hence, we can state that this after-crisis period was saved by Chinese demand.

On the top of that, Australia was offering a higher interest rate that developed economies; the cash rate in 2012 was 3.5%, while it was 75bps, 50bps and 0bps in Europe, UK and US respectively. It was also the only economy not to fall into a recession after the Financial Crisis in 2008, and is one of the few countries left with a triple-A rating. One interesting fact about Australia is that the last recession happened in 1991, and the country is on its way to surpass the Netherlands and its 26 consecutive year of economic growth (between 1982 and 2008).

The problem (or the curse) of all export-driven economies in periods of booms is how to deal with a strengthening currency. Thanks to its mining industry (primary industry and contributor of the country’s economy), Australia has experienced several episodes of mining boom in its history, bringing interest of foreign investors in both the country’s assets and currency, which tend to result in a currency appreciation. A mining boom resulting in a real exchange rate appreciation is what economists have called the ‘Dutch Disease’ as a persistent strong currency tends to have a negative effect on exports and various import-competing industries.

Therefore, when the Australian Dollar started to trade above parity against the greenback, there were many talks of an overvalued currency, from 20 to 30 percent above its historical mean according to some economic models.

J. May 2013 and beyond: QE Taper, End of the Super-Cycle and the Freefall of the Aussie

 On May 22 2013, the announcement of a potential “QE Taper” by Fed chairman Ben Bernanke triggered a sudden spike in volatility, with an aggressive sell-off in the emerging market. As a reminder, the Fed had been on a $85bn monthly purchase program since December 2012 at that time. Hence, the sudden comments from US policymakers created a little panic in the market that we now refer as the Taper Tantrum. Della Corte, Riddiough and Sarno (2016) worked on global imbalances and currency prermia, showing that debtor countries issue riskier currencies and offer a [currency] risk premium to compensate the risk in high periods of volatility.

Following those comments, the Aussie Dollar experience a 16 percent devaluation between May and September 2013, which was the start of a bear trend in the commodity currency. The fall in commodity prices in 2014, which analysts called ‘the end of the commodity super-cycle’, in addition to the 2014 Dollar rise and lower expected growth rates printed by China, pushed down the Aussie to a low of $0.68 in the beginning of 2016 (the same time when the front-month WTI oil contract was trading at $26 per barrel).

Since then, USD/AUD experience a consolidation, up north 10 cents mainly due to a US Dollar weakness over the past 7 months. As you can see on Chart 3, commodity prices have been steady over the past with Oil (WTI) trading at mid-40s.

III. Case study: The Aussie and the Carry Trade

The carry trade is one of the most popular strategies in the currency market, and simply consists in borrowing the currency with the lowest yield (i.e. the Yen) and invest in the currency with the highest yield (i.e. the Aussie). Chart 4 represents the JPY/AUD spot rate overlaid with the SP500 Index between 2002 and 2012. As you can see, the carry strategy during all that period was heavily correlated to equities, which tells you that you should treat carry trade currencies like a risk-on asset (i.e. equity), and that risk-on assets [all] tend to do bad in periods of rising volatility (i.e. VIX). Hence, a traditional long-equity investor who thought he was diversified by holding a carry trade portfolio experienced significant drawdowns during the financial crisis. The SP500 Index plummeted from 1,300 to 800 when the JPY/AUD exchange rate fell almost 50 percent in the summer 2008.

There is a vast amount of literature on carry trade and currency crashes; for instance, Brunnermeier, Nagel and Pedersen (2009) showed that carry trade strategies are negatively skewed, and that this skewness is due to sudden positions unwinding (carry traders are usually very leveraged). Hence, we now say that carry trade strategies ‘go up by the stairs and down by the elevator’.

In my opinion, the JPY/AUD chart is one of the (if not the) most important chart in Finance, and especially for short-term investors like myself. Every morning, I start my day with a coffee in front of the JPY/AUD, to see if something happened overnight. In Chart 5, I plotted a 5-minute history data of the JPY/AUD (black line) overlaid with the SP500 index (purple line). We can clearly see that a higher JPY/AUD is usually accompanied by a higher stock market; a sort of Pavlovian response of Cheaper Currency = Higher Equities. Hence, an positive overnight momentum on the Aussie Yen (i.e. Yen depreciation) is a good signal for the economy, and can be usually translated by ‘nothing serious happened in Asia’ (either China, Japan or Australia). However, a strong  Japanese Yen appreciation, like the one on August 28th / 29th in our chart, isn’t usually representative of a positive signal in the market, and equities tend to be red in Asia, Europe and US usually. My typical reaction would be to see what happened in Asia. This time, the Yen Strength was due to the headline of North Korea firing ballistic missile over Japan. Big {negative] overnight moves are usually link to disappointing Bank of Japan meetings, Australia lowering interest rates or a Chinese Yuan sudden devaluation.

Chart 1. USD/AUD exchange rate history (Source: Reuters)

AussieHist

Chart 2. USD/AUD spot rate (candlesticks) and the BCOM Index (line) (Source: Reuters)AussieBCOM

Chart 3. USD/AUD spot rate (black line) and the Oil prices (WTI, red line) (Source: Reuters)

AussieOil.PNG

Chart 4. JPY/AUD spot rate (candlesticks) and the SP500 Index (red line) (Source: Reuters)AussieSPX.PNG

Chart 5. JPY/AUD (5-min) spot rate (black line) and the SP500 Index (purple line) (Source: Reuters)AUDJPY.PNG

Figure 1. USD/GBP exchange rate since 1971 (Source: Bank of England)

GBP.PNG

Figure 2. Australia Terms of Trade History and Real TWI (Source: Gillitzer and Kearns, 2005)

Picture 1. Aussie Exports for 2015 (Source: OEC)Aussie Exports.PNG

Fighting against the Aussie…

An interesting development overnight was the Australian Q2 inflation data which is approaching the higher band of the 2-3% RBA target range. Australia’s trimmed mean CPI, the indicator the RBA officials look at which excludes volatile items that are included in CPI, rose from 2.6% to 2.9% in the second quarter (expected at 2.7%). The news lifted the Aussie to 0.9450 against the greenback as it slowed down the market’s expectations of another rate cut further this year.

AUDUSD started to recover from its last-week ‘losses’ after RBA Governor Stevens didn’t mention anything about the exchange rate overvaluation at a charity lunch in Sydney on Tuesday. As you can see it on the chart below, the increase in the 2-year AU-US yield spread (in blue) has pushed AUDUSD (yellow bars) to higher levels and the pair is now flirting with its resistance at 0.9460. A breach of that level could easily bring us to the next resistance area 0.9475 – 0.9500 (which corresponds to levels we saw in the beginning of the month).
I remain bearish on the Aussie and I think that a bounce back above 0.9500 could be another interesting level to start shorting the pair with a stop loss above 0.9560. My medium term target remains at 0.9200.

AUD-Spread

(Source: Reuters)

Another graph that I like to watch is AUDJPY. As you can see, the pair is approaching its first strong resistance at 96.00 (currently trading at 95.90). It seems that the market has been rejecting AUDJPY above this level over the pas few months, and for those who are not convinced on the AUDUSD trade, it could be also interesting to enter a short position on AUDJPY at current levels, with a stop loss above 96.60 and a first target at 94.60.

AUDJPY-23Juy

(Source: Reuters)