Australian dollar April 2017

Australian dollar to hold in 2017 before steep fall in 2018.

Westpac excels in currency and commodity forecast polls

We were pleased to have been informed by Bloomberg that Westpac has finished second in its survey of exchange rate forecasters for the March quarter. The survey includes 62 organisations and covers forecasts of 13 currency pairs over 2017.

In addition, we finished first in an equivalent Bloomberg survey of forecasters of Australia’s key commodity export, iron ore.

These multiple pair forecasts can only be successfully covered with an overriding theme with internally consistent forecasts to reflect that theme.

Forecast structure is based around USD view

For some time Westpac’s overriding theme has been firstly that due to widening interest rate differentials, the US dollar will consistently outperform each of the major currency blocks: Europe; Japan; China; Other Asia; and other emerging markets.

In that regard, we have actually lifted our near term profile for US Federal Reserve policy, with the FED set to raise rates in June and December this year and with risks for an earlier second tightening, possibly in September.

USD to appreciate against all major currency blocks...

The decision on the timing of the second tightening will be contingent on the strategy for policies around reducing the size of the Federal Reserve’s balance sheet, by allowing maturing securities to “run-off” rather than being reinvested. Arguably, this is equivalent to the FED “selling” securities, with traders liking to follow FED actions, “if the FED is selling, I am selling”. Such a change in balance sheet policy is likely to boost US long term rates, providing support for the US dollar. We have already seen an unsustainable reshaping of the US yield curve with the long end seemingly oblivious to a more hawkish Federal Reserve.

... as the Fed hikes in 2017 and 2018.

The 10 year bond rate holds around November levels, whereas the one year rate has lifted from 0.75% to 1.0%, reflecting an accelerated rate hike program from the FED. This fall in the risk premium seems unsustainable, particularly in light of expected FED policy changes. A more realistic risk premium and higher bond rates will further boost the US dollar.

Over the course of 2017 and 2018, we expect the USD to appreciate by 7.7% against the Euro; 8.2% against the Japanese Yen; 10.3% against the Singapore dollar; and 5.4% against CNY.

The second theme is that, in turn, all the major currency blocks will outperform the Australian dollar over the course of 2017 and 2018. This is largely driven by an expectation that Australia’s commodity price index will take a considerable hit over the course of the next two years.

AUD to depreciate against major currency blocks ...

We expect the AUD to depreciate 5.1% against the EURO; 5.0% against the Japanese Yen; 3.0% against the SGD; and 7.3% against the CNY. Over that period we expect the AUD to depreciate by 12.4% against the USD.

We maintain our call that despite yield differentials moving further against the AUD through the course of the second half of 2017, the real jolt to the AUD will occur in 2018, when a slowing China and a considerable deflating of the speculative commodity bubble will weigh heavily on commodity prices.

... with most of the fall to occur in 2018...

Through 2018 we expect the bulk commodity index to fall by 38%; including near 50% falls in coking coal and iron ore prices and a 20% fall in the oil price.

We note that the iron ore price has fallen from US$92/t to US$75/t over the course of the past month. That correction has always been part of our scenario; but we do not expect that pace of deterioration to be sustained through the second half of 2017, as China’s fiscal and monetary policies seek to maintain stability in the lead up to November’s National People Congress. However, beyond that, fiscal and credit policies are likely to be tightened, easing demand for commodities.

... as commodity prices move sharply lower.

Since our last report, the AUD has traded down from 77US¢ to 75US¢, partly reflecting that sharp correction in the iron ore price. However, we expect that for most of 2017 the AUD will hold in a fairly narrow range against the USD, although the bias will be to the downside. That will be despite the marked narrowing of the interest rate differential, although through 2017 the differential will remain positive. Recall that the short end differential with the US has really only ever gone negative in the period from 1997 to 2001, when the AUD was commonly trading in the 50¢’s range against the USD. That negative differential can be expected to reach around 0.5% by the second half of 2018, intensifying pressure on the AUD.

Bill Evans, Chief Economist

Reproduced from the April 2017 edition of Westpac market outlook

Business focus also has the following articles from the April 2017 edition of Westpac's Market Outlook;

Australian interest rates April 2017

The Australian economy April 2017

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.