Rudi's View | Mar 21 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck
The Australian bond market underwent a small but not insignificant transformation on Friday and Monday as a priced in rate cut over the next few months was quickly replaced with the possibility of another interest rate hike.
As such the Reserve Bank of Australia has achieved what it wanted to. All it took was for RBA Assistant Governor Malcolm Edey to amend his scheduled speech to the Australia and Japan Economic Outlook Conference on the global economy to include a section on Australia and reiterate the RBA’s hawkish bias.
As this is a rather unusual move for an RBA official to make, the market understood the message and jumped into action.
The overall change in (bond) market sentiment can have wider implications over the next few months with some currency experts now stating the Australian dollar may well break through the US$0.80 level soon. This would come as a major surprise for the majority of market experts who have penciled in a gradual decline for the currency towards US$0.72 by year end.
The action by Malcolm Edey comes as no surprise given recent ongoing releases of strong economic data showing retail sales, consumer confidence, forward indicators, wages growth and GDP all remaining strong, indicating the Australian economy has relatively easily digested three rate hikes in 2006 and remains on a firm footing.
It was just that local bond investors, taking the lead from the US market where possible rate cuts remain talk of the day, had failed to take notice. They have now.
At least one leading economist has flagged a possible change in view over the next few weeks. Deutsche Bank economist Tony Meer wrote on Friday that if the local activity indicators continue their pattern of upside surprises and the March quarter CPI reading would show underlying inflation growing by more than 0.7% on the previous quarter, he would revise his call on the RBA Board’s May 1st Meeting from a 35% risk of a rate hike to further tightening by 25 basis points. This would take the official cash rate in Australia to 6.50%.
Others, such as Westpac chief economist Bill Evans, one of the few who already penciled in one more rate hike towards the end of calendar 2007, have said they will pull forward their timing forecast to May if economic data remain strong and the March quarter core CPI figure reads 0.75% or higher.
With this, the overall tone seems to be set for the remaining two weeks as the Australian economic calendar goes through a quiet, uneventful period. This will change from April 2 onwards when the Australian Bureau of Statistics (ABS) will release retail sales data for February. After that we will see official statistics updating the market’s insights into housing finance, the Australian labour market but above all into consumer price inflation in the March quarter.
In between the RBA will have another board meeting but nobody expects a change to the status quo following the April 3 meeting.
The ABS will release the March CPI figures on April 24. Assuming economic data from early April onwards continue to add to the overall picture of a strong and healthy Australian economy, this will be the most highly anticipated economic release this year (so far, at least).
The change in market view comes at a time when other factors seem to have turned into an overall increasingly supportive environment for the Aussie currency also. Growing concerns about a widening problem with sub-prime housing loans in the US are likely to put continued pressure on the US dollar. This trend may well be exacerbated if central banks in Japan and Europe continue to signal further monetary tightening remains on the menu outside the US.
Equally important is that economists worldwide continue to believe economic growth outside the US is likely to surprise on the upside this year. Until recently, the same view applied to the US until the problem of sub-prime loans emerged which is now regarded a nasty threat.
As a result, many commodities experts believe current market expectations are once again too conservative and most natural resources, including crude oil, are likely to surprise on the upside in the months ahead. If accurate this should further support the Australian dollar.
On Monday oil specialists at UBS issued a report which predicts crude oil will soon again be priced in the high US$60s per barrel – and remain there for at least 5-6 months.
If such a scenario unfolds, investors are likely to zoom in on global inflation again. It would certainly reduce the perception that the Federal Reserve Bank can quickly resort to cutting interest rates if sub-prime loan problems would spill over into other parts of the US economy. But it would also feed expectations that central bankers elsewhere will have to tighten further to keep global inflation contained.
In Australia the outlook for inflation is now seen as the single most important factor that will decide whether domestic interest rates have peaked for this cycle, or whether another hike will follow.
Currency experts at ANZ now acknowledge that if the USD remains on the defensive the Australian dollar would seem to have a genuine chance to break above the 2004 high of 0.8005. Were this to happen the currency would likely move swiftly higher with ANZ pointing at the 1996 high of 0.8215 and the 1990 high of 0.8405 as the next likely targets.
Paradoxically, this would weigh on the inflation outlook and thus limit the scope for the RBA to tighten. It is for this reason that ANZ “feels” any move beyond US$0.80 may well lead to new highs for the currency, but it would not be sustained on a longer-term basis.
The Australian dollar seems to have settled at around US$0.7950 ahead of this week’s FOMC interest rate announcement.
