From Bill Evans at Westpac:
Over the course of the last month, the Australian dollar has traded up from USD0.745 to USD0.77 and now back to around USD0.755. Despite this usual volatility we have remained comfortable with our target levels of USD0.74 by year’s end, then falling to USD0.68 by end 2017.
As usual, our core views are largely framed around our expectations for relative interest rates in Australia and the US compared to market expectations; our views on the key commodity prices which impact Australia – particularly coal, iron ore, LNG and crude oil; and our general assessments of the “risk appetite” environment.
With respect to the yield differential story we expect that while markets are currently pricing in around a 50 basis points narrowing of the yield differential between Australia and the US we expect a 75 basis point narrowing. With the RBA on hold and the FED tightening in December 2016 and June and December 2017.
That difference may not seem sufficient to justify a fall in the AUD from USD0.75 to USD0.68 by the end of next year. Part of the story is that US markets are so convinced of a benign US FED in 2017 the realisation that the FED will deliver on those two hikes next year, following December’s hike, will see markets raising expectations for 2018 and, as is the nature of FX markets, that revised profile for the FED will be anticipated upfront in the pricing.
In discussions this week with an FOMC member who I would describe as a “major dove” (and a voter next year) he made the key points that: inflation would not get back to the FED’s 2% target until 2020; and that the NAIRU or natural rate of unemployment (the unemployment rate below which inflation rises due to wage pressures) is 4.5% – well below the FOMC Consensus of 5%.The US unemployment rate decreased by only 0.1% this year – from 5.1% to 5.0%. If the NAIRU is as low as 4.5% then we may be waiting some years before wages start to threaten inflation.
Inflationary expectations also figure prominently in this dovish analysis. He argues that inflationary expectations are only around 1.75% and there is no sign of them rising. Of course the risk with using the theoretically attractive concept of expectations is that they are so difficult to measure. His approach is to take a wide range of measures and consider the directional movement in these measures.
Theoretically he might be correct about his assessment of the NAIRU but inflation pressures may build in spite of benign wages if expectations are rising. He also asserts that allowing inflation to drift above 2.5% is the most appropriate approach.
Central banks have the tools to deal with high inflation – their concerns are deflation in a world of secular stagnation. Our thinking is more in line with the FOMC consensus that the natural rate of unemployment is near 5% and we expect to soon see wage pressures emerging. But this framework is most likely the favoured approach of Chair Yellen – hence “inflationary expectations” and “natural rate of unemployment” become the key buzz words from my perspective for analysing her remarks.
But something in addition to the wider interest rate differential will be driving our expectation that the AUD will trade down to USD0.74 by year’s end and down further to USD0.68 by end 2017.
We are also expecting a reversal in the recent boom in bulk commodity prices. Spot coking coal has lifted from USD85/t in June to USD212/t in early October. That lift along with higher thermal coal prices and a sustained elevated level for iron ore has boosted our fair value for the AUD by US 4¢ over the last few months.
The current price of coking coal is well above the cost of production for both Australian and Chinese miners. We estimate Australian production costs at around USD 60 p/t.
A key factor in this price surge has been the Chinese policy to limit Chinese coal mines’ activities to just 276 days per year. Currently, coal production in China is down 15% over the year. However, following this price surge the Chinese authorities are responding and have already eased production limits. In Australia, industrial disputes and operational issues have disrupted supply in the Bowen Basin. We can expect production in Australia , China, and other producers to lift to take advantage of these “super” profits.
There are precedents for the impact of a rapid supply driven lift in coking coal prices. Between October 2010 and April 2011, spot coking coal prices surged from $210 p/t to $330 p/t – an increase of 57%. That was in direct response to floods in Queensland which sharply reduced Australia’s production. By November of 2011, prices had regressed to around USD230 p/t – a net increase over the year of 9.5% which probably accurately reflected the boost in demand.
The supply adjustment from Australia was, of course, delayed due to the time required to restore the condition of the mines. We expect that the production adjustment will be swifter in this instance as we are already seeing with Chinese mines rapidly coming back on stream.
Iron ore prices have also been holding well above production costs.(Australian costs estimated at around USD 30 p/t). This has been due to a number of factors: stronger than expected Chinese steel production, due to a flurry of housing related construction demand in the first half (now fading) and boost to exports; low levels of steel inventories (boosting steel prices); a 7% contraction in Chinese production; and Australian producers focussing on cost cutting rather than lifting production to take advantage of wide profit margins.
Overall, because most of these increases in bulk commodity prices are supply driven they are unlikely to be sustained. We expect supply to adjust to take advantage of the super profits.
We are forecasting falls in iron ore prices (10% in 2016 and a further 10% in 2017); falls in coking coal prices (15% in 2016 and 50% in 2017); and falls in thermal coal prices (15% in 2016 and 15% in 2017). Taken together, those components indicate a 30% fall in Australia’s bulk commodity index by end 2017 and a hefty US 5¢ fall in the fair value of the AUD.
