You use it every day.
It’s how you pay your bills and put food on the table. It’s what you earn for a living at your job every day. It’s the grease that keeps the economic cogs turning.
It’s money — or more specifically it’s the Australian dollar. Our national currency.
As far as currencies go it’s actually pretty new. The first Aussie dollar was introduced on February 14 1966, which just happened to be Valentine’s Day. And Australians all across the nation have fallen in love with our dollar ever since.
52 years has given the dollar time to develop and grow. And nowadays the dollar is one of our most important economic tools.
Unfortunately, most people don’t understand just how critical it is.
They’re just happy just to collect their paycheck and be done with it, never wondering how the dollar really impacts them in the wider economy.
What these people don’t understand though is that the dollar is an amazing tool. One that can show you what’s really going on in the economy today. Information that can help guide your financial decision-making.
Which is exactly why you’re reading this. It’s all about being smart with your money. And it starts with the dollar.
What is an exchange rate?
For the most part when anyone talks about the dollar they’re talking about the value of the dollar. More specifically the value of the dollar compared to other currencies — the exchange rate.
The most commonly discussed and exchanged pair is between the Australian dollar (AUD) and the US dollar (USD). The reason for this is simple: the USD is the most traded currency on the planet. It’s the gold-standard of currencies.
Every currency on the planet has a pair with the USD. And almost every central bank in the world holds US dollars. Most of the time to use as a reserve currency.
All of that is why it’s the most commonly measured.
However, the trade-weighted index (TWI) is also a common indicator. Rather than a comparison of just one currency, the TWI covers multiple. Providing a more holistic view of how the dollar is faring overall.
It works by giving each currency in the TWI a unique ‘weighting’. Which measures the relative importance of a currency for our trade.
For example, China’s currency — the yuan — is currently weighted the highest at 27.46%. Which obviously doesn’t come as a big surprise. China is after all our biggest trading partner.
Conversely, the New Zealand dollar only gets a weighting of 4.21%, making it the seventh heaviest currency in the WTI. This is due to the smaller amount of trade we do with New Zealand.
These weightings aren’t static though. Every year they are reviewed and updated. Ensuring that they are always up to date in providing the best data possible.
Generally speaking the AUD/USD pairing and the TWI actually move in sync. Though there are rare occasions where they will part ways. Such was the case during the 1997 Asian financial crisis.
For now though we’ll only focus on the AUD/USD pairing as the most common and important exchange.
The moving Aussie Dollar and you
Whether you’re trading the Aussie dollar directly, trading shares or simply just buying groceries then understanding currency movements can help you.
What most people really care about is where the dollar is headed. Whether it’s going up or down in value, there is always going to be winners and losers. And it impacts you more than you might think.
First though, let’s look at how a moving dollar works.
The short answer is demand. If more people want to buy the dollar than sell it, it goes up. If more people want to sell than buy, it goes down — simple.
What isn’t simple though is how this demand plays out. There is a wide variety of different factors that affect demand for the dollar, ranging from broad macroeconomic outlooks to the everyday price of goods and services.
Let’s start with the basics though: trade.
In Australia we pride ourselves on our agricultural industry. We produce some of the best food and drink in the world. And the world wants what we’ve got. Here’s an example.
The US decides that they want some of our amazing steaks. So we say sure, we’ll sell you some steaks for AU$100 a kilo. The US accepts and they pay for our steaks. But we don’t want USD, we want AUD.
So the US has to exchange some USD for AUD. Let’s assume for now the pair are equal — $1 US dollar for $1 Australian dollar. So the US pays exchanges US$100 for AU$100 and buys a kilo of steaks.
The US loves our steaks so much that they keep buying them regularly. But then one day, the Australian dollar drops in value. Now AU$1 is only worth US$0.90. The US are very happy with this development. They can now buy a kilo of steaks for only AUD$90.
Meanwhile in Australia we’re not feeling so cheery. We’re now getting less money for the same amount of product. But it’s not all bad. Our cheaper steaks mean that the US starts importing more of them.
Then when you add other countries to the mix things get even more complex. Our cheaper dollar means that our products are now priced more competitively. Which means maybe Canada will want to import our steaks now as well, because they’re cheaper than the steaks that the UK is selling.
The weaker dollar impacts our imports as well, though. Now that our dollar doesn’t have as much value, imported goods are more expensive. Which means that while we may be selling more goods and bringing in more money, we’re also paying more for other goods from overseas.
As you can see it’s a fairly simple relationship. It’s just that with more variables it becomes increasingly complex. A one to one trade is easy. Factoring in trade between the entire world, not so much.
But when it comes to worldwide trade for Australia, commodities are our bread and butter. Our natural resources are some of our most in-demand products. Iron ore, coal, aluminium and even gold are some of our most traded goods.
So when the prices of these commodities move they affect the dollar. An increase in commodity prices will mean buyers will need to provide more Australian dollars, increasing demand and therefore the value of the dollar. If commodity prices fall, then buyers will need less Aussie dollars, easing demand and lowering the dollar’s value.
Again, drawing on the same relationship between supply and demand.
But the really tricky question is what caused the dollar to move in the first place. Why did the value of the dollar drop from $1 US dollar to 90 cents in our steak scenario?
Well there are a number of reasons, but let’s go through some of the more common ones.
Terms of trade
The terms of trade (TOT) represents the difference between export prices and import prices — usually expressed as a ratio. For example if our TOT is 2:1 then we’re exporting twice as much as we import, a positive result.
Simply put, the more positive the result, the stronger the dollar will be. The dollar will be in higher demand.
If our TOT is negative then that results in a deficit in the current account. We’re spending more on imports than we’re making from exports. Which increases supply of the Aussie dollar in the market, therefore lowering its value.
Once we enter a current account deficit, we need to borrow money to balance it. The bigger the deficit, the more we borrow.
One way to combat this debt is to print more money to pay it back. Except printing money has a serious drawback. Inflation.
Yes, the RBA’s nemesis is one of the most critical influencers of the dollar. Too high and the value of the dollar begins to tank. Keep it low though and the value of the dollar will generally rise.
Again, it’s an inverse relationship. As inflation goes up, the less we can buy with our money — and our buying power drops. In the case of deflation — or negative inflation — our dollar soars in value, letting us buy more goods with fewer dollars.
It’s the tool used by the RBA and all central banks to fight inflation. It represents the rate of interest that banks like Commonwealth, ANZ and Westpac pay on overnight loans. In other words, how much banks have to pay to get a hold of more money.
Higher interest rates generally attract more foreign investment. They’re getting more returns from their investments. Which drives more demand for the currency.
What does it mean for our economy?
Understanding how and why the dollar moves is just another tool for your investing arsenal. By using these fundamentals you can examine different trends occurring in the broader economy.
All you have to do is break down how an event may impact demand or supply for money, which generally will be covered by the indicators above.
The tricky part is that nothing occurs in isolation in the economy. Everything hits all at once, which can be overwhelming. This is why the dollar is constantly moving around. It has to keep up with all the latest news and data.
And while the movements can be erratic, it’s better than fixing the exchange rate. The strength of a ‘floating’ dollar is shock absorption. Any major movements in imports or exports in particular dramatically impact the value of the dollar. If the value was fixed however, major movements in the TOT would cause significant inflationary or deflationary pressure.
Pressure that is extremely hard to control. Just imagine if inflation moved as much as the dollar does. The RBA would be raising the lowering interest rates every week!
Which is why the dollar acts as a buffer. It takes the brunt of economic impact which can then be eased into the economy. Smoothing out volatility and allowing the RBA to focus on policies to help keep the economy stable.
This is why you need to keep an eye on the dollar. If an economic shock is on the cards – like a recession – you’re probably going to see it begin with the crash of the dollar.