A Bold Prediction for the Aussie

The Reserve Bank of Australia believes the decline in the country's exchange rate is necessary for its economy to transition to growth from the non-mining sectors.

While a resurgent Australian economy should ultimately flow through to our investments there, as US investors, we definitely miss the performance enhancement we enjoyed in our Portfolios when the aussie traded above parity with the US dollar.

Although the S&P/ASX 200 generated an enviable total return last year of 20.2 percent in local currency terms, much of that gain evaporated when translated back into US dollars.

From that standpoint, those who'd enjoy at least a temporary boost from the exchange rate could be in luck. Morgan Stanley just made a bold prediction that the Aussie could ascend to parity with the US dollar again later this year, as investors stretch for the higher yields offered by the country's government debt.

In a research report, the US bank says cash will be flooding into Australia as the government issues AUD5.5 billion in debt per month. Australia is one of the few remaining countries with a coveted triple-A rating, while the country's 10-year notes currently offer the highest yield among its peers, recently at 3.8 percent.

According to The Wall Street Journal, it's the Japanese who are doing most of the buying. From September 2013 through this past April, Japanese investors bought AUD10.9 billion of assets. Last year, they sold AUD34.2 billion, so there's presumably some dry powder remaining to at least match those purchases.

On this basis, Morgan Stanley raised its forecast for the Australian dollar, predicting that the Aussie will reach parity with the US dollar by the end of the year.

The Australian dollar currently trades near USD0.94, up 8.3 percent from its three-year low in late January. However, it's still down about 14.5 percent from this cycle's high in mid-2011.

According to Bloomberg's survey of institutional economists, the aussie is forecast to average USD0.905 for the remainder of 2014, then decline to an average of USD0.87 in 2015. Though the currency is projected to rebound to USD0.90 in 2016, it's expected to renew its decline in the years thereafter.

In fact, Morgan Stanley's estimate is a definite outlier among its peers, according to Bloomberg's aggregation of private-sector forecasts. Among institutions that have offered relatively recent forecasts, the next highest prediction for the aussie's fourth-quarter performance is from Wells Fargo, which expects the currency to hit USD0.96.

But Morgan Stanley believes the aussie's rise will prove to be short-lived. For full-year 2015, the bank forecasts the Australian dollar will decline to USD0.88, which is essentially in line with its peers.

If the aussie does renew its ascent, however, it's difficult to predict how long momentum could sustain its upward trajectory, especially given the currency's safe-haven appeal amid a tenuous global recovery.

After all, the Australian dollar remained stronger far longer than many expected. Indeed, it was the US Federal Reserve's announcement toward the middle of last year that it was planning to curtail its extraordinary stimulus that finally triggered the aussie's selloff.

Although the Reserve Bank of Australia's (RBA) rate-cutting cycle had already been underway for two years by that point, the currency had remained stubbornly high. And even above USD0.90, the RBA has characterized the exchange rate as uncomfortably high.

From the RBA's perspective, the currency would have to fall to the mid-USD0.80s to make a meaningful difference for the country's economy.

As such, while we certainly stand to benefit in the short term if Morgan Stanley's prediction proves correct, from a longer-term perspective it's best for the aussie to trade below parity with the US dollar.