For some time, financial markets have enjoyed the support of the world’s major central banks – particularly the US Federal Reserve (the Fed) – in the form of extremely low or zero short-term rates and massive quantitative easing.

Even though conditions in the US economy have improved significantly over the past year or so, many observers have wondered just how markets would react if the Fed were to begin unwinding some of that extraordinary support. In other words, could the US economy continue to grow if the Fed started to turn off the tap? If the market’s immediate reaction to hints that it might do so is any guide, the answer is no.

A shiver looking for a spine

After its latest policy meeting in June, the Fed brought forward its estimate of when it might be able to start removing some of its stimulus measures. However, it added that this depended on how the US economy unfolds and that policy would have to remain very supportive for quite some time.

Still, this was enough to send shivers down the spines of investors across the world.

The Australian dollar, which has been under considerable downward pressure this year, fell sharply after the Fed’s announcement, trading just below US$0.92 for the first time since September 2010.

More recently, the currency has declined further, to below US$0.91. This means that since its high of over US$1.10 in July 2011, our currency has fallen by around 18 per cent against the greenback.

Exacerbating the weakness of our currency have been the continuing doubts about the durability of China’s economic growth, with the release of some weaker than expected Chinese economic data.

World share markets, including Australia’s, fell back sharply after the Fed’s announcement, but have since recovered.

 Where next for the Aussie dollar?

The Australian dollar, after proving remarkably resilient during other recent periods of share market volatility, is once again behaving as a measure of global risk appetite.

At MLC, we make no attempt to forecast the level of the Australian dollar, but we do consider carefully how the currency might behave in a range of economic scenarios.

For some time we have viewed the Australian dollar as overvalued and, more importantly, highly vulnerable in a number of adverse scenarios. For example, a period of sharply weaker Chinese economic growth would be clearly negative for Australia’s key mining exports and economy.

In that scenario, our dollar would likely fall, perhaps quite some way. MLC’s diversified funds remain substantially underweight to hedged global shares, and therefore overweight foreign currency. This is essentially a risk management position, and one that is working in the current environment.

 Outlook for the economy

For the Australian economy, the impact of a weaker Australian dollar right now is a clear positive. Those industries that have clearly suffered from the strength of the currency – education, manufacturing and tourism spring to mind – are finally getting some relief.

Since floating in 1983, the Australian dollar has done an excellent job of cushioning the Australian economy from the impact of global shocks. The recent reaction of financial markets may be a little surprising given that the US economic news this year hasn’t been too bad. It’s been positive enough to give the Fed reason to believe the economy may not need support for as long as it previously thought.