Currencies | Oct 03 2012
– RBA cuts, AUD falls
– technicals suggest further weakness
– fundamentals argue otherwise
By Greg Peel
The futures market was expecting it, but the majority of economists wasn't. Mind you, when it is suggested the interest rate futures market is “forecasting” a rate cut, or indeed several rate cuts as is currently the case, it's a bit of a furphy. Interest rate futures are indeed used for speculation but most fundamentally they are used for hedging funding requirements and obligations, so realistically a lower futures rate implies hedging against, rather than predicting, a lower RBA rate.
Economists were nevertheless not surprised the RBA cut its cash rate by 25bps to 3.25% yesterday. Fundamentally, China has slowed, and this has been reflected in lower commodity prices. Lower commodity prices and overall uncertainty have led to resource sector projects being shelved, suggesting the expected peak in resource capex in Australia will be earlier and probably lower than the central bank had anticipated.
Meanwhile, the non-resource economy remains in the doldrums. If this week's PMIs are a gauge, things are only getting worse here on the earth's surface. Today saw the release of the September service sector PMI, which has fallen to 41.9 from 42.4 in August. Monday saw the equivalent manufacturing sector PMI fall to 44.1 from 45.3. Bearing in mind these numbers represent rates of change, and not quanta of change, contraction in both sectors is accelerating significantly. Friday will see the construction sector PMI which has also been in contraction for some time.
The end result of the low PMIs is job losses, even if they don't seem to be obvious in the monthly ABS jobs data which are quite misleading anyway. The unemployment rate does not measure the number of Australians out of work, just the number on the dole, and there's a big difference. Throw in a housing sector which might be looking a little less dead but is still a long way from health, and the RBA has reason to fear inflation.
Indeed, the RBA by now will be fearing contraction in the GDP if things don't improve.
And as we all know, a big part of the problem is the strong Aussie dollar. The Aussie has not obligingly fallen as it is meant to when commodity prices fall. Our AAA-rating is attracting offshore bond investors, but foreign stock market outflows largely offset. It's really foreign direct investment in our assets, with ongoing capex requirements, that is keeping the Aussie elevated. One only has to look at all the massive LNG projects, then mining projects, to know where the money's going. And it all has to be converted to Aussie.
The currency did at least oblige yesterday by falling about a cent to the mid US$1.02s. This is better than earlier levels seen this year above 105, but not the numbers we really should be seeing on a commodity price basis – numbers well below parity. But if nothing else, this one cent fall has sparked the tea leaf readers into action.
According to GAIN capital's Kathleen Brooks, the Aussie broke key support when it fell through 1.0320. which now suggests a downside target of 1.0180. However, Brooks believes the Aussie will stay range-bound in the medium term between parity and 1.06. It's a bit of a different story for the euro-Aussie (EURAUD) which Brooks sees as having entered a new paradigm after the surge through A$1.2480.
Bear in mind that the Aussie dollar (AUDUSD) is denominated in US dollars while the euro-Aussie is denominated in Aussie dollars. That means if our currency is weaker against the US then the exchange rate is lower, but if our currency is weaker against the euro the exchange rate (under convention) is higher.
Brooks believes the breakout in the euro-Aussie could trigger more euro buying to take the rate to A$1.28.
The technical analysts at FXCM also believes the Aussie dollar will trade to below the US$1.02 mark after yesterday's move, which broke both the 50-day moving average and the previous support line from back to June. Throw in your Fibonacci's and your other how's your fathers, and FXCM sees a break of 1.0175 as setting up for substantial downside, with further technical support levels down to 1.0110. A break above 1.0360 would dismiss the downside thesis.
If we look at the Credit Suisse overnight swaps market rather than just the interest rate futures market, another 114bps of cuts is expected in the next twelve months on top of the one we just had. We only need 50bps more an we would see the lowest cash rate in 53 years. The RBA's aggressive cutting post-GFC only took us to 3.00%, or 25bps lower than today.
It is interesting that BA-Merrill Lynch chose yesterday to raise, rather than lower, its Aussie forecasts. The analysts have now set 1.01 as their year-end target, up from 0.98. Their end-2013 target nevertheless remains at 0.94. Such a number seems like a dream at the moment.
Merrills notes that the strong currency has actually been helpful up to now because it has kept a lid on the inflation which might otherwise have been generated by the resources boom. But if the Aussie continues to remain elevated despite lower commodity prices, and the RBA refuses to intervene directly in forex markets like just about every other central bank in the world, then a lower cash rate is the only solution. Says Merrills:
“With commodity prices (and hence Australia’s terms of trade) now declining, the continued strength in the A$ will likely begin to weigh more heavily on the economy, exacerbating the decline in real income growth and forcing governments into more contractionary fiscal policy positions in order to preserve their promised budget surpluses.”
Wayne Swan is always good for a laugh, and he didn't disappoint yesterday. The government's fiscal discipline (read hell or high water surplus) has provided the opportunity for the RBA to reduce borrowing rates, Swan declared with a swagger. Anyone else would realise that the government's fiscal tightening for purely political reasons (now desperate) has forced the RBA into offset monetary easing as the last line of defence against recession.
Merrills' conclusion is that the cash rate will have to fall further from here. The analysts are looking for 50bps in total, being two moves in November and February.
Commonwealth Bank's forex team agrees there could be another cut next month, but they would see it as a buying opportunity for the currency. The big picture has not, CBA notes, changed significantly. Iron ore and base metal prices have bounced back from their initial dip on ECB and Fed policy responses, and there are signs the global economy is “stabilising”. Foreign investors seeking AAA will keep on investing, CBA assumes. New Zealand's central bank has cut its cash rate down to a record low 2.5%, the analysts note, yet the Kiwi (NZDUSD) is trading at only 6% below its all-time high.
With the Fed having pledged a zero cash rate out to 2015, and unlimited QE, CBA suggests 1.0220 for the Aussie would be a good entry point to get long once more.
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