The resilience of the AUD has come as a surprise to many in the market, particularly as the foreign exchange value of the AUD has remained elevated despite the decline in interest rates (both in absolute and relative terms) and the decline in the terms of trade (mostly due to declining Australian export prices).
I have nit-picked before, noting that neither ‘broken relationship’ is sufficient to demonstrate that the AUD is overvalued, but today i want to give an alternate view.
The view is set out by John Cochrane, in his 2011 paper Understanding policy in the great recession: Some unpleasant fiscal arithmetic. The paper is in the spirit of Sargent and Wallace (1981), and is based around the following two equations:
The top equation does most of the heavy lifting – it states that the real value of consolidated government liabilities (Money and Bonds) is equal to the net present value of future government surpluses.
Once you start thinking of both Money and Bonds as liabilities of the Australian Government, it clears things up. In particular, it makes clear that if the credit quality of Australia improves, both the foreign exchange value of the AUD and the price of her bonds might increase.
If we allow capital lambda to include a risk premium, and have global capital markets, then we have what we need to explain the recent data – a decrease in the relative riskiness of the Australian Sovereign has increased the relative valuation of her liabilities.
When this occurs, we should expect that both M and B will increase in value – and that is what we have observed.