Westpac ups Australian dollar forecast

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From Westpac just now:

Westpac has revised the outlook for the Federal Funds rate and the Australian dollar.

When we last produced our forecasts in mid December we expected that the Federal Funds rate would be increased by 25 basis points in June and December in 2018 to reach 1.875% by year’s end.

We envisaged “neutral” as zero real and expected that “zero real” would be sufficient to allow the FED to go on hold through 2019 as other major central banks, particularly ECB and BOJ, embarked upon their own tightening programs.

Associated with that higher Federal Funds rate would be a rising bond rate and rising US dollar with targets of a rise of around 5.5% in the USD Index (DXY) and an increase in the US 10 year bond rate to 3% from 2.35% at the time.

Associated with that expected increase in the USD; an expected fall in Australia’s Commodity Price Index of around 20%; and a deteriorating yield differential as the RBA remains on hold in 2018 we expected a fall in the AUD from around USD 0.765 to USD 0.70 .

This commodity view, which seems at odds with the current surge in global optimism is partly based on our below Consensus forecast for Chinese growth in 2018 (6.2%, down from 6.8%) as the authorities slow investment growth and embrace more aggressive financial reform.

In a surprising development the USD Index has in fact depreciated by around 4% since mid-December despite a sharp widening in the US yield differential, (the US 10 year rate has increased from 2.35% to 2.62% and the three year rate has increased from 1.95% to 2.17%).

In response to this lower starting point for the USD and the expected impact on business investment from the accelerated depreciation allowances in the US tax package we have raised our forecast for growth in the US economy to 2.5% from 2.2% in 2018.

Lower tax rates; a lower USD; and a subsequent 6% lift in the US share market have markedly eased financial conditions (despite higher bond rates) clearing the way for a FED rate hike in March.

We now see the profile for the FED as 3×25 basis point hikes in March; June; and September.

That would lift the FEDERAL FUNDS rate to 2.125% by September, comfortably above “zero real” and an appropriate point to pause.

We retain our target of 3% for the 10 year US bond rate while recognising upside risks given the higher profile for the FED.

The “puzzle” as to why the USD has weakened despite widening rate differentials could be explained by concerns around budget deficits associated with the Tax Package or heightened expectations for more aggressive tightening “signals” from ECB and BOJ; or the “over shoot” of around 9% in the USD Index through 2015 in anticipation of the FED’s first rate hike. (The USD INDEX has subsequently lost all its gains through 2015 and now sits at around its end 2014 level before the market’s excitement about FED tightening).

Relative market confidence in the US has also lifted in the last month with the S & P 500 rising by around 6% compared to 3.3% for the Europe Index.

Our current preference is to look through these explanations; and assess the current weakness in the USD to be unsustainable.

Accordingly, associated with the upward revision to the FED profile and the much lower starting point for the USD that we saw in mid-December we are now expecting a 7% lift in the USD Index over the course of 2018, (compared to the 5% we envisaged in mid- December).

The rise in the AUD from USD 0.765 to USD 0.800 since midDecember can be largely attributed to the fall in the USD (most models attribute around 70% of the increase in the AUD/USD to USD weakness).

Other factors supporting that AUD outperformance are a 4.5% lift in Australia’s overall Commodity Price Index and a more positive assessment of Australia’s economic outlook with associated more hawkish outlook for the RBA’s rate policy.

In that regard Westpac retains its call for RBA to remain on hold through 2018 while we retain our “end 2018” forecast level of the Commodity Price Index still indicating around a 20% fall in the Index.

It should also be noted that markets are anticipating that the yield differential between Australian overnight rates and US rates will be around – 28 basis points by end 2018 whereas Westpac expects a differential of –62 basis points.

Markets have come a long way from six months ago when they were predicting that the yield differential by end 2018 would be +35 basis points compared to the Westpac’s forecast at the time of – 38 basis points. (not far from the market’s current –28 basis points).

At that time (mid 2017) we were comfortable to forecast eventual contraction in the AUD/USD 10 year bond spread to zero (from the prevailing 55 basis points) by end 2018. However that was when we expected the short end margin at –38 basis points. With that expected margin now increasing to –62 basis points we have to recognise that the spread will go negative in the second half of 2018.

In mid-December we expected an 8.5% fall in the AUD through 2018 to reflect a stronger USD; a benign RBA; and that 20% fall in Commodity Prices.

With the bigger increase (7% vs 5%) in the USD now expected and RBA and Commodity Price views unchanged we now expect a larger fall in AUD/USD (10%) than was the case in mid December.

However with the starting point much higher (USD0.80 vs USD 0.765) our revised target for AUD/USD by end 2018 is now USD 0.72. That “new” level for the AUD by year’s end would be consistent with an NZD/USD level of USD0 .65.

More or less the MB view.


David Llewellyn-Smith is chief strategist at the MB Fund which is currently long international equities that will benefit from a falling Australian dollar so he is definitely talking his book.

Here’s the recent fund performance:

Source: Linear, Factset
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The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees. October monthly returns are currently at 4.9% for international and 4.2% for local shares.

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The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. The MB Fund is a partnership with Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.