Little to arrest Aussie's upwards trajectory
- AUDUSD has been trending upwards since early June despite the rate cut
- Money markets in Australia are pricing in further movement in the policy rate
- The correlation between FX cross rates and rate differentials has broken down
- Spreads don’t matter much now: It’s absolute rates that count
By Max McKegg
The northern hemisphere is in the midst of its summer slumber and there is little on the data calendar Downunder this week. It is an opportunity then to step back and have a look at the medium term prospects for the Aussie dollar.
The AUDUSD has been trending upward since early June, despite the Reserve Bank of Australia cutting its policy rate to a record low of 1.5% earlier this month with further cuts expected.
Counteracting monetary easing has been an economy growing above potential, helped along by strong resource and services exports. Commodity prices have been rising, with iron ore in particular defying gloomy predictions of a supply driven slump, while import prices remain low.
As a result, the Reserve Bank is forecasting that the worst is over for Australia’s terms of trade. The decline in this index coincided with the equally big drop in AUDUSD from 1.1080 five years ago to around 0.7600 now.
Source: Reserve Bank of Australia
While the correlation between commodity prices and AUDUSD is strong over time, in the short term the main influence is the interest rate differential, more specifically, the shape of the forward curve.
As the chart below shows, money markets in Australia are pricing in further movement in the policy rate, perhaps to as low as 1% next year, as the Reserve Bank struggles with its inflation mandate.
That would lower the Australia’s rate advantage over the US, and on past form pull AUDUSD down. But the previously strong correlation between FX cross rates and interest rate differentials has broken down recently.
Spreads don’t matter much now: It’s absolute rates that count, and on that basis Australia is a AAA rated “high yielder”.
Australia’s yield curve remains attractive in a global context but the window of opportunity for offshore investors to buy into it while avoiding currency risk is closing, as it is in other high yield markets, including the US. See here.
Source: Bank of New Zealand
Meet the new boss - same as the old boss
One of the key assumptions underlying the forward curves in the chart above is that central banks will not deviate from the goal of achieving 2% inflation in the medium term, no matter how low they have to take interest rates.
If one of them was to have a change of heart then all bets would be off for that currency.
It’s worth noting then that in mid-September RBA governor Glenn Stevens will hand the baton to his successor (and current deputy) Philip Lowe. As such, little change in approach to monetary policy would be expected.
However, as part of the changeover the new governor and the Treasurer Scott Morrison will negotiate and sign a "statement on the conduct of monetary policy".
This statement sets out the RBA’s statutory mission: A stable currency, full employment, and the economic welfare and prosperity of the people of Australia.
Normally this isn’t contentious, but the underlying assumption has been that the best way to achieve these multiple goals is to target an inflation rate of 2-3% over the medium term.
That assumption is now being questioned by some, including politicians, as the Consumer Price Index drops well under the target band.
Prime Minister Malcolm Turnbull’s party doesn’t control parliament’s upper house and pressure could come from there to make some changes to the statement on the conduct of monetary policy.
Options include widening the band to 1%-3% or, more radically, switching the target to nominal GDP growth. Less contentious would be the RBA extending the period of its economic forecasts.
At the moment, the self-imposed framework is two years; that is, its projections must show inflation holding at or returning to the 2%-3% band within that period. Changing this to three or four years would give them more flexibility to adjust to or ride out temporary influences, mainly from offshore.
New Zealand’s Reserve Bank finds itself in a similar position to the RBA and has been asking for a bit of breathing space for monetary policy. This is how RBNZ governor Graeme Wheeler put it in a speech yesterday:
“Provided sufficient flexibility is allowed to accommodate the frequent and often severe impact of external shocks, the most important contribution monetary policy can make to promoting efficiency and the long-run growth of incomes, output and employment is the pursuit of price stability.”
A far more radical change to the statement of intent would be to switch from an inflation band to a nominal GDP target, say 5%. It wouldn’t matter whether this was achieved via 5% economic growth and no inflation; no growth and 5% inflation; or some combination of both. There is a growing number of economists worldwide showing interest in this idea.
Any substantial tinkering with the monetary policy agreement would elicit a response in AUDUSD, and probably a positive one if it suggested a lack of resolve to raise the inflation rate.
That’s because the RBA would be under less pressure to cut interest rates. Meanwhile the odds are increasing that some G10 country will break ranks and abandon inflation-targeting, whether it be Japan, the EU, Switzerland or one of the many others that have painted themselves into a corner with record low interest rates.
With a new Reserve Bank governor about to be sworn in, Australia has a chance to lead the way. We’ll see if it has the nerve.
In the meantime, with an economy growing above potential, stable commodity prices, an attractive yield curve and a dithering Fed, its hard to see AUDUSD reversing its uptrend just yet.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.