Australia | Mar 30 2016
-RBA unlikely to respond to higher AUD yet
-Some fundamentals underpin the higher AUD
-AUD appears around fair value
-CBA analysts suggest steady cash rate in 2016
By Eva Brocklehurst
Australia's dollar has done an about turn. A weakening trend was foiled with remarkable speed in March, Commonwealth Bank analysts observe. Where to from here? What are the implications for official interest rates?
As of March 1 the Australia dollar was US71c and forecast to go lower. By late March it rebounded to US76c, with forecasts starting to appear suggesting it could hit US80c.
The analysts observe this resilient push by the currency has re-ignited the issue of official interest rates. Those calling for rate reductions are becoming more confident, but should they be?
The analysts describe the current policy approach from the Reserve Bank of Australia as one with a conditional easing bias. The central bank has indicated that inflation is benign and if the domestic economy needs a boost the board can act to lower the cash rate. Whether this will occur depends heavily on the Australian dollar's trajectory, as a stronger currency is a constraint on growth and curbing rates is a means to push it lower.
As the currency has receded somewhat from its highs of the month the analysts do not expect the RBA to act just yet, as any response requires a view on where the currency is going and whether its rally is long lasting. On that note, they observe the Australian dollar has risen more dramatically against the US dollar and assume the RBA would have been disappointed with the dovish tone espoused by the latest US Federal Reserve statement.
The conclusion remains that with US unemployment low and inflation nearing the Fed's target, US interest rates should slowly move higher. The analysts suspect this will occur sooner than the early 2017 time slot priced in by US financial markets.
There is also support for this expectation from the divergence with other central banks, with 2016 likely to witness further negative moves on rates by both the European Central Bank (ECB) and the Bank of Japan (BoJ) as these two expand their quantitative easing policies. This should provide some upside potential for the US dollar.
One thing the analysts are quite certain about is that the RBA will not be implementing quantitative easing. Australian interest rates further along the curve remain attractive to global investors, limiting the central bank's ability to influence the Australian dollar.
One aspect that may be of concern to the RBA in the current economic environment is deflation. Falls in inflation expectations blunt the impact of central bank stimulatory policies. The analysts observe this occurred following the moves by the ECB, BoJ and the Reserve Bank of New Zealand.
On the other hand, wage and price expectations in Australia have remained relatively stable over the past couple of years even with the decline in oil prices. Hence, the analysts believe the need for the RBA to respond in this way is less urgent.
The RBA has increasingly used rhetoric to pressure the currency in recent years, or "jawboning" as it is called in money market circles. Two aspects of this increasing use of jawboning stand out for the analysts: concerns are most prominent when the Australian dollar has diverged from fundamentals and are reduced when the currency moves into a US70-75c band.
Some fundamentals have underpinned the recent move higher. Commodity prices have improved, with the CBA commodity price index up 13% in US dollar terms on levels at the end of 2015. Moreover, central bank actions in Europe and Japan have increased the relative attractiveness of Australia as an investment destination.
The CBA analysts model fair value for the Australian dollar at US76c with the Trade Weighted Index (TWI) at 63. On this basis it appears there is no fundamental reason for the RBA to cut the cash rate. The US70-75c band is considered to be the comfort zone. Lower than this and policy makers will start to worry more about inflation risks than growth support, in the analysts' view.
Another debate is about what level of the currency causes economic pain. There is evidence, the analysts maintain, that this is higher than many would have expected. One piece of evidence is exports. There was a significant spike in the number of companies exporting in 2013/14 and this occurred when the Australian dollar was still high, averaging US92c throughout 2013/14. The drop since then should push the export trend along, the analysts suggest.
Non-resource exports may continue to surprise on the upside in 2016. This lift in exports is an unexpected outcome from an extended period of income weakness which the analysts maintain forced companies to focus on costs, with a risk that capital expenditure and labour hiring would be affected negatively.
One positive aspect, they note, is that the lift in productivity allowed the companies to adjust to the extended period of a strong Australian dollar. They believe restrained labour costs are turning the nominal depreciation in the currency into a real depreciation.
The analysts also observe the RBA was surprised at the rate of economic growth in 2015 and now believes unemployment can fall further. This lifts the hurdle for a rate cut. Moreover, there is debate about whether official rate reductions work now the cash rate is at a very low level. Another concern is that households will consider a reduction to record low rates a sign of an economic downturn.
In sum, the CBA analysts expect the cash rate will remain at 2.0% over 2016.
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