Australian dollar July 2017

Australian dollar: resilient of late ahead of downward move in 2018 H1.

Aussie dollar trades at the top of its range ...

Over the course of the last month the Australian dollar has remained in a fairly narrow range of around USD 0.75 and USD 0.77. It is currently near the top of this range.

Our forecasts in the June Report, at which time the AUD was trading around USD0.76, were for the AUD to drift somewhat lower to USD0.73 by December this year. The big expected move in the AUD has always been envisaged for 2018.

... supported by higher commodity prices.

We retain our call for AUD to fall back to USD 0.65 by end 2018.

Consequently we are not particularly surprised that AUD has held well in the USD0.75–0.77 range over the last month.

Recognition of a significantly weaker profile for the AUD is not expected to gather momentum until the first half of 2018.

Factors we expect to change sentiment in the AUD from current market positioning are as follows:

A weaker AUD profile to emerge in 2018 H1, as ...

1. US interest rates are expected to rise much more quickly than current market expectations. We envisage a US rate hike by September or certainly December with two more hikes in 2018. Market pricing currently anticipates only a 50% probability of a hike by year’s end and only one further hike in 2018. While Chair Yellen noted that rates were nearing her assessment of neutral she also emphasised that she expected the neutral rate to rise over the course of the next two years or so. Overall, we expect a further 0.75% increase in the Federal funds rate over the next two years compared to market expectations of around 0.40%.

... US interest rates surprise to the high side ...

2. There has also been an “overshoot” in negativity around the US and the USD in the face of disappointment in Trump’s progress toward heath care; tax; infrastructure; and regulatory reform. Despite three rate hikes in December; March; and June the USD Index (DXY) has actually fallen by 2% since prior to the US election in November. DXY is actually down 7% since its peak in December last year as markets have lost confidence in prospects for reform in the US. Markets now seem vulnerable to some upside surprises.

... the overshoot in USD negativity reverses ...

3. While there is no way of assessing markets’ direct expectations for growth in Australia, the fact that a 0.25% rate hike is now factored in by August next year implies that markets are expecting a much stronger growth environment in Australia than our view. We continue to expect rates to remain on hold through 2018.

... Australia – US interest rate differential goes negative ...

4. Consequently our expectation for the short term yield differential between Australia and the US by end 2018 is minus 0.40% compared to market expectations of plus 0.20%. We consider that, based on historical evidence, Australian rates falling below US rates will have an exponential impact on confidence in the AUD.

... and as commodity prices retreat.

5. Consider the only previous examples of AUD short rates falling below US rates. Over the year from July 1997 when the AUD cash rate fell 0.5% below the Federal funds rate the AUD tumbled from USD 0.75 to USD 0.57. In August 1999 when AUD also fell back to 0.5% below US rates the AUD fell from USD 0.67 to USD 0.58.

We retain our call ...

6. To be sure, the AUD will remain at higher levels in the next expected episode of negative interest rate differentials due to a much more supportive level for commodity prices. However we do envisage a considerable fall in the key commodity prices through 2018. Through 2018 we expect a 26% fall in the bulk commodity Index, including a 30% fall in the iron ore price. That adjustment will be underpinned by a marked slowdown in Chinese industrial demand, as the government resumes its rebalancing policies. We also expect a lift in Australian and Brazilian production of iron ore. Because these producers have much lower cost curves than other marginal producers who prosper when demand is booming prices can fall back towards the cost curves of the highly efficient Australian and Brazilian producers. Industry reports estimate current cost curves of around USD20/t in both Australia and Brazil. Our end target level of USD40/t will still be an attractive proposition for these low cost producers.

... AUD to fall to US65¢ by end 2018.

In summary, our expectation that US rates and policy will surprise to the upside while Australian growth and rates will surprise to the downside, coupled with a slowdown in China and weaker commodity prices, still support our outlook for the Australian dollar in 2018.

Bill Evans, Chief Economist

Reproduced from the July 2017 edition of Westpac market outlook. Business Focus will no longer reproduce this article. You can subscribe to Market Outlook and other economic publications on Westpac IQ and be notified when they are available.

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.