Currencies | Apr 23 2014
-Potential delay in US dollar strength
-Slowdown in China would pressure $A
-Interest rate differentials ultimate key
By Eva Brocklehurst
What is supporting the Australian dollar at current levels? Why is it so stubbornly high? UBS observes the more obvious reasons relate to the broad-based improvement in the economic data at a time when the US data has been weaker. Less obvious is offshore demand for Australian government debt, which is back at the highest level since the euro crisis, despite a record $75 billion in federal government debt issuance this financial year. This, in part, reflects the country's AAA rating and yields above 4% beyond 10 years, in a global yield market where BBB euro debt is yielding around 3%. Secondly, from the broker's observations, Australian exports have gained market share in China to the detriment of Russia, Brazil and India. This is reflecting Australia's lower relative cost and higher quality, more reliable supply.
Despite this, looking ahead, UBS thinks the currency will move lower in the second half of the year. Markets are expected to focus on higher global rates ahead of the transition to a higher US Federal Reserve funds rate. as the tapering of quantitative easing is finalised. China's fading commodity intensity coupled with Australia's higher supply should pressure both commodity prices and the Australian dollar lower. If Australia's core CPI – to be reported April 23 – is lower than UBS expects at 0.6%, this should help push the Aussie down, as it signals the Reserve Bank is likely to maintain a steady cash rate for the next six months. The federal budget in May is also expected to provide some fiscal drag.
It's 12 months since the US Fed announced the tapering of quantitative easing and Commonwealth Bank analysts have decided to fundamentally change their outlook on the US dollar. They do not expect that currency to significantly strengthen until the real Fed funds rate turns positive in early 2016. Some mild strength is expected as the US-G6 two-year swap spread begins to turn positive in early 2015. The analysts emphasise that their view on the Fed's tightening cycle has not changed. This is likely to be gradual. It's the view on the US dollar reaction that has changed. Tapering has not supported the US currency as the market expected. This has been difficult to judge, the analysts acknowledge, because the Fed's balance sheet is in uncharted territory. Moreover, the US current account deficit, while recently improving, remains a large gap to finance. Combined with negative real US yields this suggests a delay to US dollar strength.
As a result of the changes to the US dollar forecasts, Commonwealth Bank analysts have lifted forecasts for the Australian dollar. As well, the transition in the driver of Australian GDP towards housing construction and consumer spending from mining investment is occurring at a better rate. The analysts see this as encouraging the RBA to pull back from easing and favour a more neutral stance. The bank's economics team now expects the RBA will start tightening in November and increase the cash rate by 100 basis points to 3.5% by July 2015. This will underpin the Australian dollar should they prove correct.
The analysts also note the RBA has stopped talking the currency lower. The reasons, according to the analysts, are because net exports are currently driving growth and domestic inflation is uncomfortably high. The RBA also risks losing credibility if it keeps trying to talk down an unresponsive currency. The analysts are only forecasting a very modest decline in Australia's terms of trade, not enough to put a significant dent in the Australian dollar's strength. One factor that could turn this view on its head, the analysts maintain, is if China decides to sacrifice some economic growth in the short term to deepen structural reforms. A major slowdown in that quarter would provide a headwind to Australia's terms of trade and, hence, the Australian dollar.
HSBC observes some soft data from China, a substantial drop in iron ore prices and a more hawkish US Fed should have pointed to a weaker Australian dollar, yet the currency appreciated 4.4% since the beginning of the year. These factors reflect HSBC's three C's that dictate the trajectory of the Australian dollar: China, Commodity and Carry.
The analysts highlight that, while concerns are growing regarding China's financial system, the impact of these stresses so far on the Australian dollar – a liquid proxy for the Asian growth story – has been muted. Despite a drop in the price of iron ore, Australia's largest export by volume, the currency did not sustain the dip. As the RBA spoke of a period of stability in interest rates for the first time since the easing cycle began the US Fed added to tapering and raised Fed funds projections. This is the third C, the carry trade, with interest rate differentials expected to ultimately underscore the Australian currency's fortunes. HSBC thinks the Australian dollar will move down against the US dollar as the year progresses and targets US86c by the end of 2014. The currency is expected to eventually succumb to rising interest rate expectations in the US.
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