Australian dollar March 2017

Australian dollar: policy divergence ‘differential’ uncertain, direction clear.

Trading a tight USD 0.75-77 range ...

Since our last report the AUD has remained in a tight range between USD 0.75 and USD 0.77.Fluctuations have been largely driven by expectations and assessments of policies from the US Federal Reserve.

... buffeted ...

The low point was reached when markets revised expectations for the next Fed hike, bringing forward the move from May/June to March. That was largely in response to a speech from Chair Yellen on March 10 when she indicated that the time was right for another move. As a result markets priced in two and a half hikes in 2017 up from less than two hikes before the speech.

... by shifting Fed views.

However, market expectations became even more aggressive with ‘whispers’ anticipating that the new forecasts from FOMC members following the release of the March decision would indicate a faster tightening profile than December’s pace of three hikes in 2017; 2018 and 2019. In the event, only the 2019 profile was lifted, from three to three and a half (the median forecast of FOMC members).

We expect Aus-US cash differential ...

Given our view that the Reserve Bank will remain on hold through 2017 and 2018, the path of Fed tightening has significant implications for our medium term outlook for the Australian dollar. Following the March increase the differential between Australia’s overnight cash rate and the US federal funds rate stands at +62.5ppts. Markets and the FOMC forecasts now point to that differential shrinking to around zero by year’s end. Markets are currently pricing in two 25bp rate hikes in Australia by end 2018. Westpac differs from that view expecting no change.

... to turn deeply negative by end 2018.

FOMC expectations for 2018 are for a further three 25bp rate hikes while markets are a little more circumspect anticipating two. Under Westpac’s RBA view and the FOMC/market view for the US, the cash rate differential will turn negative reaching around –75bps by end 2018. That would be a historically wide negative differential. The only time when Australian short term rates fell below US rates in recent times was in the 1997–2001 period, when the margin peaked at –50bps. During that time, the AUD averaged USD0.63, including in 2000 when it averaged USD0.57.

Fed’s own policy expectations ...

Market pricing is heavily influenced by Fed expectations. So what is behind the FOMC’s medium term rate view? Essentially central banks assess their policy stance relative to a ‘neutral real’ rate – a level where policy is in equilibrium and is neither stimulating nor constraining the economy. When the US economy used to grow at 3-3.5% ‘neutral real’ was thought to be around 2.5%. However given FOMC expectations that the long run growth rate is now just 1.8% – largely due to a sharp slowdown in the growth rate of the work force (ageing; lower immigration) – ‘neutral real’ is now thought to be lower. Fed officials now assess the rate as 1% compared to 2.5% under a higher growth model.

... shaped by views on ‘neutral real’ rate ...

The assessment of 1% is likely based as much on art as it is science. Further complicating the analysis, the Chair herself assesses the current ‘neutral real’ rate as 0%. Accordingly the ‘neutral real’ rate can be expected to lift as more temporary factors currently holding it at abnormally low levels gradually ease, particularly the caution that has dominated in the aftermath of the Global Financial Crisis.

... that are debateable.

But even at an assessed zero ‘neutral real’ the current policy stance is expansionary (Fed funds rate at 0.875% is 1% below inflation) with policy projected to take a smooth path back to neutral (1.8%). However even that assumption has to be tested – perhaps the ‘precautionary’ headwinds associated with the aftermath of the GFC mean that ‘neutral real’ is in fact -1%!

We expect that the timing will be a little slower than currently expected by the FOMC, mainly because these headwinds associated with the GFC, including the fragility of the global economy (BoJ and ECB still conducting aggressive QE policies), will probably see ‘neutral real’ hold nearer zero than 1%. And this discussion does not touch on the potentially huge swing factor of US fiscal policy.

Policy divergence vs RBA is still clear ...

Nevertheless, even under these uncertainties we cannot overlook that the US is at full employment and close to its inflation target and that Australia has an unemployment rate of 5.9% (compared to full employment of 5.0%) and underlying inflation rate of 1.5% – well below the 2.5% target.

... with commodity slide to take AUD to USD0.65.

This discussion serves to highlight the uncertainties around the precise yield differential between Australia and the US in 2018 but it seems to us to be a fair bet that it will go negative and probably stay around those historical lows. In other reports we have argued why we expect commodity prices to be unravelling in 2018 hence our confident call that AUD will test that USD 0.65 level in 2018 – a long way from the confident USD 0.77 we see today.

Bill Evans, Chief Economist

Reproduced from the March 2017 edition of Westpac market outlook

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

Australian interest rates March 2017

The Australian economy March 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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