Three downside risks to the AUD

Wed, 29 Aug 2018  |  

This article first appeared on The Wire website, for FIIG, at this link: https://thewire.fiig.com.au/article/commentary/opinion/2018/08/21/three-downside-risks-to-the-aud 

 ----------------------------------------------

Three downside risks to the AUD

A certain calm in currency markets, including for the Australian dollar, was briefly punctured in early August when the Turkish lira collapse spread to other emerging markets and sparked a jump in the US dollar.

Since early 2015, the AUD has traded over 90% of the time in a 71-78 cent range against the US dollar. The moves outside this range have been marginal and short lived.  It was and still is rare for the AUD to be so steady, for so long. A bevy of factors that normally impact its value have had minimal lasting impact or have been offset by news elsewhere. Even the Turkey and emerging markets disruptions appear short lived with the Aussie dollar bouncing back in recent days.

That said, for reasons other than the global turmoil, we are probably starting to see the early stages of a realignment of the AUD which will have important implications for other markets and investors. In recent months, the AUD has been trading in an even narrower range around 72 to 76 cents, with the data flow and run of events having little lasting impact.

Any upbeat news is offset by downbeat news, meaning the net effect is inconsequential.  Think of the following events: US interest rate hikes, commodity price falls, clear weakness unfolding in the Chinese economy, the emerging markets ructions and the changing outlook for Australian interest rates are all big news, but have not been enough to see the AUD break out of its range.

As the second half of 2018 unfolds, factors that usually have the greatest influence are skewing the AUD downwards. This means it is more likely than not that the AUD will fall to 70 cents or lower by this time next year. A move to 65 cents, around 10% down on current levels, is likely if some of the key drivers reassert historic influence, most notably, interest rate differentials.

Such a currency move would have implications for the economy, economic policy and other markets, including for stocks and bonds.

Three key downside risks:

1. Interest rate differentials

All Australian interest rates along the yield curve from the cash rate to the 10 year government bond and beyond, have fallen below those in the US. This should have been a factor undermining support for the AUD as investors look for higher nominal returns from the US. What is often overlooked in this era of global investment flows, is that even though the Australian yield curve is below the US curve, many other high industrialised countries have yields still well below those in Australia.

Look at the yields in the Eurozone, Japan, the UK and Canada. These markets have an interest rate structure that is materially lower than in Australia. As a result, these markets remain less attractive from a nominal yield perspective, at least relative to Australia, providing some support for the AUD or at least stemmed the decline.

Recent monetary policy tightening from the Federal Reserve and the Banks of England and Canada are starting to close the interest rate gap. This suggests AUD weakness is likely if rate hikes continue and the RBA remains on hold. But with the Bank of Japan and the European Central Bank firmly on hold with super stimulatory policy, an AUD free fall will be unlikely.

2. Commodity prices

The moderation in global growth since the start of 2018, has seen various commodity indices track lower. So far, this has had little impact on the AUD, partly as the price of iron ore has held up well, relative to the price of other commodities. Australia’s international trade performance has also been solid, as seen in the run of surpluses on the monthly international trade balance.

As a barometer of global economic growth and hence the AUD, broad commodity price indices are usually reliable. The 8% drop in the Bloomberg Commodity Price index in recent months fits with news of less solid growth in China, the Eurozone, the UK and Japan.  For the AUD, the trend is threatening to undermine key support for Australian income growth. Hence the economic growth and monetary policy pressures.

Over the next six to 12 months, global economic conditions continue to moderate, including in the US as the sugar hit of the Trump tax policies start to fade. The risk is for further weakness in commodity prices and additional downside pressures for the AUD.

3. Political, economic or policy risk

Foreign investors shy away from a country and its currency when risk builds. That risk can be political, economic or policy driven and includes an assessment of civil unrest or natural disasters. In Australia, we face the prospect of the RBA keeping interest rates too high for too long which could require unexpected and outsized rate cuts in 2019 and 2020 to return the economy to an even keel. Local rate cuts with the rest of the world on hold or tightening would undermine the AUD.

A key reason for downside risk to growth and interest rates, is the fall in house prices, which for now have been orderly and not too extreme.

If prices remain weak and pose a further threat to household wealth, as well as to consumer spending and bank balance sheets, the RBA would quickly and pragmatically move to lower interest rates. Then there is risk associated with the Federal election, which is due at some stage before the middle of 2019. Will we see policy flip flops, back flips and downright dumb issues coming to the fore? Any such policy brain-snaps would make the headlines and create anxiety for international investors are hence the AUD.

What will a lower AUD mean for bonds and stocks?

A lower AUD, when linked to fundamental economic shifts, is good news. The export sector kicks higher, import competition is reduced and firms with an export focus or who compete with importers will gain. A lower AUD also adds to the attractiveness of Australian assets, including AUD denominated debt, as investors try to pick the low point for the currency. Foreign investors are more likely to buy the AUD when the exchange rate is 70 cents than when it was 90 cents and higher.

Borrowing in the local market can also be cheaper for foreign issuers, adding to supply of new debt instruments that local investors can access.

The forecasts

On balance, the risks favour a fall in the AUD from now through to the middle to latter part of 2019.  On the assumption of a further deterioration in the interest rate differentials, a 10% fall in commodity prices from current levels, some risk pricing as house prices fall and the election campaign hotting up, the AUD could ease to 65 cents. Falls below this would require a very troubling outlook for the economy which, for now, seems unlikely.

Only if there is an unexpected surge in global and domestic activity and an early rate hike from the RBA, will the AUD hit 80 cents. In economics and markets, nothing can be ruled out, but on the balance of current facts and pressures, it is the downside that looks more likely for the AUD over the next year.

comments powered by Disqus

THE LATEST FROM THE KOUK

The misplaced objective of the government of delivering a surplus, come hell or high water, has gone up in smoke

Tue, 07 Jan 2020

This article first appeared on the Yahoo Finance web site at this link: https://au.finance.yahoo.com/news/the-governments-test-in-2020-220310427.html   

---------------------------- 

The misplaced objective of the government of delivering a surplus, come hell or high water, has gone up in smoke

For many people, the cost of the fires is immeasurable. 

Or irrelevant. 

They have lost loved ones, precious possessions, businesses and dreams and for these people, what lies ahead is bleak.

Life has changed forever.

As the fires continue to ravage through huge tracts of land, destroying yet more houses, more property, incinerating livestock herds, hundreds of millions of wildlife, birds and burning millions of hectares of forests, it is important to think about the plans for what lies ahead.

The rebuilding task will be huge.

Several thousands of houses, commercial buildings and infrastructure will require billions of dollars and thousands of workers to rebuild. Then there are the furniture and fittings for these buildings – carpets, fridges, washing machines, clothes, lounges, dining tables, TVs and the like will be purchased to restock.

Then there are the thousands of cars and other machinery and equipment that will need to be replaced. 

What's ahead for the Australian economy and markets in 2020

Thu, 02 Jan 2020

What's ahead for the Australian economy and markets in 2020

Happy New Year!

2020 will be a year where Australia’s annual GDP will exceed $2 trillion, our population will get very close to 26 million people and we will clock up 29 years with no recession.

It is also a year where the economy will be a dominant issue for policy makers, will drive what happens to interest rates, will help drive investment returns and will feed into the well-being of the Australian community. 

2020 kicks off with relatively good news in terms of economic growth, even though the labour market is likely to remain weak, with wages growth struggling to lift and inflation remaining below the RBA’s 2 to 3 per cent target. The Reserve Bank may have one more interest rate cut in its kit bag, but by year end, the market is likely to price in interest rate increases, albeit modestly.

The ASX, which had a great 2019 is set to be flatten out, in part driven by the change in the interest rate outlook, but it should get a boost from better news on housing and household spending.

In terms of the specifics, I have broken down the 2020 outlook into a range of categories and given a broad explanation on the issues underpinning the themes outlined.

GDP Growth

It’s a positive outlook. A pick-up in GDP growth from the current 1.7 per cent annual rate is unfolding, with the only real issue is the extent of the acceleration.