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Optimism from Australia's central bank drove Chinese shares sharply higher overnight, with investors looking to the Aussie statement as a proxy for bullishness on the mainland economy.
Article / 22 November 2017 at 0:37 GMT

Bears say stars are aligning against AUDUSD

Managing Director / Technical Research Limited
New Zealand
  • Rate differential expected to disappear between Australia and US
  • Terms of trade to fall in line with bulk commodity prices 
  • RBA forecasts inflation below target for next two years
 
By Max McKegg
 
Bears have been stalking the Australian dollar over the last couple of months, dragging AUDUSD down from 0.8100 to 0.7550. Not content with that, some analysts have upped the ante, predicting the Aussie will fall into the mid-60s. But the Reserve Bank of Australia thinks the economy will expand at a solid pace over the next two years and has dropped its previous stance that the exchange rate still needs to “adjust”.


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 According to the bears, the stars are aligning against AUDUSD. Photo: Shutterstock
 
Let’s have a look at the reasons the bears have it in for AUD.
 
The first is interest rate differentials. Market pricing suggests the gap favouring of Australia over the US will close in mid-2018, as shown by the yellow and grey lines converging in the chart below. The RBA holds its policy rate at 1.5% while the Federal Reserve lifts the fed funds target to the same level. But market pricing is well below the Fed’s “dot plot” for rates. If the Fed sticks to its guns the RBA rate could end up 50 basis points below fund funds by this time next year.
 
This move at the short end should transmit along the curve. Even now Australian government 10-year bonds yield only 20 basis points more than the US equivalent. That advantage will likely evaporate and could turn negative.

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Source: Bank of New Zealand
 
What’s likely to happen if rate differentials turn against AUD? 
 
Bearish forecasters point to the last time this happened: the June 1999 to December 2000 period, as shown in the chart below (click to enlarge). The yield differential went as low as minus 50 basis points at the short end and the 10-year spread went briefly negative as well. AUDUSD fell from 66 cents to 50 cents.


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Source: Metastock
 
We should be wary of making exchange rate predictions based only on rate differentials. After all, the US versus Germany 2-year yield spread is close to 250 basis points, a gap not seen since 1999. And yet still EURUSD holds up.
 
Anticipating this argument, the AUD bears point to another brick in the wall for the Aussie: the terms of trade. As shown in the chart above, AUDUSD topped out at the same time the terms of trade peaked (mid-2011). Similarly, both bottomed out together in early 2016.
 
According to the RBA’s latest forecasts, for the next two years: “The terms of trade are generally expected to fall over the forecast period ... because Chinese steel demand is expected to be lower, while global supply of iron ore will have increased further." 

However, as shown in this chart, it does not think the index will fall under the previous low (when AUDUSD reached 0.6820).

...
 

 
















Source: Reserve Bank of Australia
 
That’s the main case against AUDUSD: the rate differential in Australia’s favour will disappear (or even go negative) and the terms of trade will retreat as the price of bulk commodities drop due to slackening Chinese demand at the same time extra supply comes onto the market. And the charts suggest AUDUSD has fallen in the past when either of these events occur.
 
However, there is another side to the story. In a speech this week RBA Governor Philip Lowe said “There has been progress in moving the economy closer to full employment and in having inflation return to the 2-3 percent range. Progress on these fronts has been made while also containing the build-up of risks in household balance sheets ... If the economy continues to improve as expected, it is more likely that the next move in interest rates will be up, rather than down. But the continuing spare capacity in the economy and the subdued inflation outlook mean that there is not a strong case for a near term adjustment in monetary policy."
 
In other words, a rate hike is on the horizon, but don’t hold your breath.
 
The more bearish AUD analysts think even this modestly positive outlook is ambitious. The RBA expects GDP growth to average a bit above 3% over 2018 and 2019 as the negative impact from the end of the mining investment boom fades and exports rise as those projects come on-stream.


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Source: Reserve Bank of Australia
  
That level of growth would be above potential and put pressure on the economy’s resources, including the labour market, even though, according to the RBA: “A distinguishing feature of Australia’s recent economic performance has been the slow growth in wages."
 
“Low growth in wages means low inflation, which means low interest rates, which means high asset valuations,” Lowe said. He estimates a jobless rate of 5% would represent full employment in Australia and that level has yet to be reached. Structural issues are also at play (workers and firms feel more competition). He adds: “But that does not mean the normal forces of supply and demand have been abandoned. Tighter labour markets should still push up wages and prices, even if it takes a little longer than we are used to."
 
From the RBA’s perspective, above-potential growth and a gradual increase in wages growth mean that inflation should gradually rise to about 2% in underlying terms (“trimmed mean” in the chart below) and a little higher in headline terms because of planned increases in tobacco excise.

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Source: Reserve Bank of Australia
 
The RBA’s inflation target is 2% to 3%. So it is saying it will only just reach the bottom of the target zone, and even then not for another two years.

Some analysts see this assessment as another reason to sell the currency. They think the RBA may be forced into a rate cut just to hold the line.
 
According to the bears, the stars are aligning against AUDUSD. The rate differential is set to turn negative; the terms of trade will head lower as commodity prices fall victim to a slowdown in China; and the RBA is expecting inflation to be below its target band for the next two years.

However, the bank is no longer saying the exchange rate needs to “adjust” lower. Indeed, it is assuming the AUD remains at its current level over the next two years.

– Edited by Gayle Bryant
 
Max McKegg is managing director of Technical Research Limited. If you would like to receive his Daily FX trading forecasts, then contact him via his contact details here. Or post your comment below to engage with Saxo Bank's social trading platform.  
2y
Patto Patto
according to this chart from Bloomberg today the rate differential for two-year bonds has already gone ...........
2y
sutiani sutiani
still open short aud/usd ,now stop loss?thanks
2y
Max McKegg Max McKegg
Outside Reversal Day yesterday
2y
Patto Patto
NZD also rallied, despite lower prices at dairy trade auction. Looks like the bears got a bit ahead of themselves on both Aussie amd Kiwi.

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