From Westpac’s Bill Evans:
As expected the Reserve Bank Board decided to leave the cash rate unchanged at 2.5% at its October meeting.
The Governor also confirmed that “the most prudent course is likely to be a period of stability in interest rates”. He was also downbeat on the Australian economy forecasting below trend growth for “several quarters” and characterising the labour market as having “spare capacity” and noticeably weaker wages growth.
We expect the Governor will maintain the “period of stability” assessment for some time yet until he can better gauge the underlying strength ofthe Australian economy (currently described by the RBA as “moderate”); whether an effective macro prudential policy can be adopted to slow investor housing; and the outlook for policy by the US Federal Reserve.
He is also still not satisfied with the level of the AUD. Since the last Board meeting the AUD had fallen by around 6.5% against the USD and around 4.5% against the Trade Weighted Index.
Nevertheless the Governor still described the currency as “high by historical standards, particularly given further declines in key commodity prices in recent months”. We expect that the Governor is going to remain disappointed on this front for some time yet.
Over the six months to early September the AUD had remained firmly in a USD0.925 – 0.945 range. We were constantly required to justify our call for a target of USD0.90 by year’s end with the implication that the call was overly pessimistic.
The AUD has now clearly undershot our year end forecast, currently printing around USD0.88. However we are not “chasing down” the AUD. We are retaining our year’s end call of USD0.90.
The factors we expected to drive the fall in the AUD – rising volatility; EUR weakness; and a lagged response to falling iron ore prices – have all materialised with gusto.
We now need to make the case for retaining our USD0.90 year’s end forecast and risk being accused of being overly optimistic. In that regardthe following arguments are key.
Currency markets typically adjust rapidly to a new level and then surprise market participants looking to ‘trend follow’ (a polite description for ‘naive extrapolation’) by stabilising in a new range for extended periods. In the recent experience the move back to and then below 90¢ has happened more sharply than expected but our experience of market dynamics now points to a period of stability.
The catalyst for the latest drop in the AUD was a sharp rise in the USD trend fuelled by a weakening euro as ECB President Draghi stepped up policy support just at the time when the Fed was retiring QE3.
Subsequently we have seen that Draghi has been unable to satisfy market expectations and the “anticipation” trade has faded. The euro initially dropped by 5% post the September ECB meeting, but following the October meeting, when Draghi’s concrete actions disappointed, the euro strengthened by around 1.2%. Quite possibly, the big near term move in the Euro is already behind us. Indeed, we are predicting stability in EUR/USD through to year end.
We are also forecasting that the iron ore price has bottomed out. We anticipate a lift of around 15% in the price by year’s end. That will be driven by a reduction in the growth in iron ore supply as we anticipate that local Chinese producers, who are already producing iron ore at costs of 10–20% above the current market price, will not re-open a number of facilities after the Golden Week holiday. (Recall this significant dynamic in 2012 when the iron ore price last fell to around $US80/t) In addition, the Chinese authorities have already announced a range of policy measures to boost the housing market in China (housing construction is the single largest user of steel) thus boosting demand. These forces are expected to gather pace through 2015, supporting a further lift of around 15% in the iron ore price. While the AUD has not fully adjusted to this year’s 40% fall, markets generally respond to surprises and are forward looking. A surprise lift is likely to see the AUD outperform the broader USD trend going through to year’s end, which we proxy by flat EUR/USD.
We expect the AUD will receive further support from around March next year, chiefly due to rising fixed term interest rates in Australia and a gradually improving world outlook which will underpin higher commodity prices. While we are not anticipating a rate hike from the RBA until August next year fixed rates are likely to be moving in anticipation of that hike by early in the June quarter.
In last week’s note I contrasted our interest rate forecasts over the medium term with current market expectations. This comparison has enormous implications for the medium term path of the AUD. Currently, market pricing for Australia implies rates on hold in 2015 to be followed by one single 25bp hike in 2016. In contrast, US markets are forecasting 65bps of hikes in 2015 and 100bps of hikes in 2016 from the FED.
For Australia we expect 2x25bps in hikes in 2015 and 4x25bps in 2016. That will be dependent on a solid lift in world growth, led by the US, particularly in 2016. A lift in world growth will boost commodity prices and, supported by attractive interest rates, the AUD is expected to move back toward parity over the course of 2016. A good way to consider that profile is to contrast our forecasts with the recently released IMF forecasts.
Recently the IMF announced a modest downgrade in their near term world growth forecasts. They now expect 3.3% in 2014; 3.8% in 2015 and 4.0% in 2016. Their near term forecasts are now more in line with our own forecasts of 2.9% (2014) and 3.7% (2015). However we have a much more optimistic forecast for 2016, expecting 4.5%.
Contemplate that market pricing for Australia. This pricing is only consistent with a weak world economy in 2016 (in contrast with both IMF and our own forecasts). The state of the world economy will be a key consideration for the RBA when they are planning the normalisation of interest rates. That current market pricing which implies Australia hardly moves rates despite the FED normalising rates by 165bps would imply a very weak AUD. Such Australian market pricing would only be consistent
with falling commodity prices and a weak world economy. The AUD would be pressured back towards the “low USD 80’s” in such circumstances – a sharp contrast to our core view.In summary our interest rate view is consistent with its implied view on world growth and will be critical for the expected path of the AUD. The medium term path for interest rates currently implied in pricing for the Australian yield curve implies a very weak profile for the AUD.
In contrast the interest rate path contained in our own forecasts points to a substantial lift in the AUD through 2016.
You’ve got to love Bill Evans. He has a red hot go, his record is good, and you never know. My own response is the following:
- the 2012 iron ore bounce was also due to 50 million tonnes of Indian iron ore exiting the market suddenly. As well, port and mill steel and iron ore inventories were very low, unlike today;
- the oversupply situation today is much larger, somewhere between a 50-100 million tonne surplus;
- the second great wave of new iron ore supply begins with Anglo-American, BHP and Sino still ramping into year end, then Rio in Q2 and Roy Hill in H2;
- Chinese property may stabilise but the adjustment is part structural (oversupply) so any rebound is unlikely to be strong;
- some kind of iron ore restock is still possible, perhaps 10% at some point through new year, then another sag into Q2 in a repeat of this year;
- global growth prospects are OK but are unlikely to deliver as hoped as US growth remains moderate, the EU slows and China weighs on emerging markets;
- the AUD definitely behaves in the manner Bill Evans suggests with it’s quick drops but no new range has been established yet and another fall to 80 cents and then rebound to an 85 cent trend makes more sense;
- that is before more falls next year as rate cuts flow after macroprudential tightening slows housing and the income and capex shocks take their toll.
MB often finds itself in simpatico with the Westpac institutional team, which is the best of the big shops, but right now we are looking at polar opposites. We have a market!
