Australian dollar February 2017

Australian dollar: strong start to 2017 sounding more confident in the outlook.

Higher commodity prices support AUD for now.

Since our last report in December the AUD has traded between US72¢ and US77¢, finishing the period at the top of that range. Little wonder given that Australia’s commodity prices have lifted by nearly 40% in the past six months.

Despite ongoing low interest rates and a significantly more competitive Australian dollar we expect real GDP growth will slow in 2018, moderating to 2.6%. That is despite the drag from the contraction in mining investment easing from subtracting 1.2ppts points in 2016 to only 0.1ppts in 2018.

Looking to 2018 ...

This is because the significant “outperformers” from a growth perspective in 2016 and 2017 – residential construction and exports – are likely to slow through 2018. In 2016, residential construction and exports directly contributed 1.7ppts to GDP growth; that is likely to slow to 0.8ppts in 2018. Moreover, the looming downturn in home building activity in 2018 will have a number of negative spill-over effects. With confidence remaining muted there appear to be disappointing prospects for household spending and business investment to fill the gap. The contribution to growth from business investment (non–mining) and household spending is likely to moderate from 2.0ppts in 2017 to 1.8ppts in 2018.

... Australian output growth to slow ...

Australia’s growth prospects are closely aligned with developments in China. Chinese direct investment has played a significant role in the residential construction boom. However, the Chinese authorities’ concerns with ongoing capital outflow are likely to weigh on offshore property investment activity. A slowdown in that support is also likely to ease pressures on house prices, particularly in 2018.

... as housing turns down ...

The boost to growth from exports has not been restricted to the boom in LNG production (expected to explain over 70% of Australia’s resource exports growth over the 2016/2018 period but also slowing by 2018). It has also stemmed from a strong lift in services exports (education; tourism; business services) which are likely to contribute 0.4 percentage points to GDP growth in 2016. China has been the dominant driver of this growth. To date there is no evidence that Chinese officials are seeking to slow tourism and education imports but concerns around the need to stabilise FX reserves in China might eventually lead to tighter controls, which would potentially impact Australia’s services exports.

... and commodity prices to retreat ...

Chinese policies also impact national income growth. We expect that the gains in iron ore prices through 2016 will be largely sustained in 2017 leading to a healthy boost in the terms of trade and national incomes. Official policies in China to boost infrastructure investment and housing activity are likely to dominate through 2017 as the current regime seeks to present a strong economy in the lead up to the National Congress in November. Thereafter policies are likely to tighten, weighing on prices; Australia’s terms of trade and incomes in 2018. Following a boost in the terms of trade in 2017 of 4% we expect a fall of 16% in 2018.

... while rising US short term rates ...

The Commonwealth government seems largely focussed on its bid to retain Australia’s AAA debt rating. In the process the government appears to be eschewing policies, such as infrastructure investment; tax and labour market reform that would provide the necessary boost to confidence to lift household spending and business investment. An ongoing tightening of regulations on the banking system is likely to see further restrictions on credit availability limiting any unexpected lift in activity from a boost in demand for funds.

... set to exceed Australian rates ...

In 2018, world growth is unlikely to provide the Australian economy with any circuit breaker. With the new US government embracing infrastructure; deregulation and tax policy, growth prospects are encouraging. But a tightening of trade arrangements is likely to dampen any benefit to the rest of the world. The expected slowdown in China in 2018 will be a further bulwark, particularly for Australia, to any lift in US economic conditions.

... together pointing to a weaker AUD ...

This scenario has clear implications for markets in particular the Australian dollar. Ongoing concerns with house prices are almost certain to keep the official cash rate on hold in 2017. Markets are finally broadly aligned with that view. However market expectations for a rising cash rate in 2018 seem misplaced. We expect the cash rate will remain on hold through 2017 and 2018. Indeed the case for lower rates in 2018 seems more reasonable than the case for rising rates.

... heading to US66¢ by end 2018.

Our scenario around two US FED hikes in both 2017 and 2018, as US fiscal and regulatory policies boost activity and confidence (in stark contrast with Australia) will see US short term rates exceed Australian rates by the second half of 2018. Note that the last time (late 1990’s) US rates exceeded Australian rates the AUD had fallen into the USD 50’s. Coupled with our expectation for falling commodity prices as China slows through 2018 prospects for the AUD appear bleak. Expect AUD to be in the mid 60’s by 2018. Indeed our fair value model points to an AUD of USD 0.63 by end 2018.

Bill Evans, Chief Economist

Reproduced from the February 2017 edition of Westpac market outlook

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

Australian interest rates February 2017

The Australian economy February 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.