Australian dollar June 2017

Australian dollar: running against tide AUD to reverse as pressure mounts.

This month, the AUD has been well supported ...

It has been an interesting month for the Australian dollar. On the whole, domestic partial data has remained soft (the labour force survey being a key exception). Further, continuing a key theme of last month, the price of Australia’s key commodities have remained under pressure, moving to new multi-month lows. Nonetheless, the Australian dollar has rebounded in June from its May low of 73.5¢ to be back near 76¢ as we go to press.

... owing to developments in the US ...

In large part, the support given to the Australian dollar looks to have come from a change in expectations for the US economy. There, available data has been a little disappointing: Q1 GDP was soft at 1.2% annualised; the May employment report also disappointed, with a more subdued pace of job creation; and inflation has shown signs of trending back below the FOMC’s 2.0%yr target – notably, the headline CPI fell 0.1% in May and core inflation slowed to 1.7%yr.

... chiefly Washington.

However, the downtrend in the US dollar looks to have had more to do with developments in Washington, namely: an impasse in the Senate on health reform; the Comey saga; and a looming battle over the debt ceiling. All of the above bodes ill for President Trump’s reform agenda, particularly for taxation and infrastructure (where there is little basis for constructive negotiation between the Republicans let alone across the aisle). Waning expectations for a growth boost into 2018 has combined with softer inflation expectations to see the US dollar fall back to the levels seen prior to Trump’s presidential win (below 97 on a DXY basis).

The tide should turn ...

Against this present reality, we continue to believe that the US dollar will re-enter a sustained uptrend through the second half of 2017 which will accelerate in 2018. Why is this the case? Simply because the FOMC will continue to slowly tighten policy out of sync with the rest of the world, given full employment has been attained and that, even in the absence of major fiscal reform, the US economy seems capable of sustaining at-trend growth through 2017 and 2018.

... as the FOMC holds course ...

Following on from the FOMC’s June hike, we look for another in September and a start to balance sheet normalisation in Q4 2017. Thereafter, two further hikes in 2018 (likely March and September) coupled with a further reduction in the Fed’s balance sheet will support the US interest rate curve. With the RBA firmly on hold, this will see the Australia/US overnight interest rate differential turn negative from March 2018 and the 10yr government yield differential fall to zero at end-2018. Both of these developments imply a much lower Australian dollar than currently seen today.

... and commodities weaken.

For the Australian dollar outlook, we also need to factor in the impact of both the recent decline in key commodity prices and our expectation that they will move lower still in 2018.

Throughout the past year, we have emphasised that the strong rally in iron ore would begin to reverse during 2017 as speculative buying reached its peak; low–cost supply from countries such as Australia continued to grow; and global growth remained modest.

Since late–February, there has been strong evidence of these forces taking hold, with the spot price for iron ore with a 62% metal content having fallen from near USD95mt to USD69mt in April; USD60mt in May; and now USD55mt in June. Futures pricing argues that market participants are increasingly becoming resigned to the current downtrend continuing, Dalian’s front–month contract having halved since early March. The price of Australia’s other key commodities have also weakened materially. The spot price of coking coal has fallen more than 50% since its peak, while Brent oil has sustained a break below USD50/bbl in the past week.

Most of the decline will come in 2018.

While we see further weakness in Australia’s key commodities through 2017, it is the second leg down in 2018 that we expect to have the largest impact on the Australian dollar. From our current year–end target of USD0.73 we expect the Australian dollar to depreciate to USD0.65 by end–2018. With respect to commodities, this will come as a result of a circa 30% decline in the price of iron ore through 2018 and a 40% fall for coking coal. Oil (Brent) is seen down a more modest 17%.

For AUD, risks skewed to downside.

To this core expectation, it is worth also briefly discussing the risks. To our mind these primarily lie to the downside for the Australian dollar. This is because, while the risks to the US economy look balanced, those for the Australian economy are skewed to the downside. On our current forecasts, GDP growth is set to slow from 2.8%yr at end-2017 to 2.5%yr at end-2018. To this view, there is the risk that the Australian labour market will underperform (weighing on incomes and confidence), and that housing investment may turn down more quickly and sharply than anticipated. While our central case forecast is for official rates to remain on hold, growth materially below trend combined with soft inflation and an unemployment rate well above full employment would be a troubling combination for the RBA and could see them shift to an easing bias of some sort.

Elliot Clarke, CFA, Senior Economist

Reproduced from the June 2017 edition of Westpac market outlook

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

Australian interest rates June 2017

The Australian economy June 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.

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