Bill Evans from Westpac still bearish AUD:
Interest rate differentials continue to be important drivers of our core view that AUD will weaken further against USD over the course of the next 12 months. We confirm our target for AUD to head to USD 0.70 through 2019.
Our forecasts for the US Federal Funds rate have been consistently above market expectations. Our analysis of current pricing suggests markets are still undecided between three or four more FED hikes. We recently lifted our target from three hikes (+75bps) by June 2019 to four hikes (+100bps). However we continue to expect the FED to pause by mid-2019 in anticipation of potentially cutting rates from 2021.
Even under the 75bps scenario we have been consistently arguing for a weakening AUD/USD through 2018 (which subsequently peaked at 0.81 in late January this year). Under our relative rate profile the AUD/USD cash rate differential would sink to an unprecedented –112.5bps by June 2019 (previous mark in the post stagflation history was –50bps in the late 1990s).
On a six month annualised basis, the core PCE is now running at 2.3% (to May) and the Employment Cost Index is rising at 2.9% (to June). This pace is somewhat faster than we had expected providing the FED with ample justification to raise rates in not only September but also December. In that regard we note that the FED has emphasised the symmetrical nature of its inflation objective and therefore not indicating any immediate concern that the momentum in the core PCE is running above the 2% target. As such, we are still expecting the gradual approach to the tightening cycle.
We now expect the FED to continue to edge rates up with an additional December hike of 25bps while maintaining the June 2019 target timing for the end of the cycle. That would indicate a peak Federal Funds rate of 2.875% by June 2019 – still short of the peak in the “dots” (the median of FOMC members’ estimates) of 3.4% by end 2020 and 3.1% by end 2019. Given our RBA outlook this revised forecast sees the spread between the RBA cash rate and the Federal funds rate reaching -137.5bps by June next year. Markets are currently pricing in a margin of just over -100bps so there is still ample scope for the AUD/USD to weaken further and the long bond spread to widen to our mid 2019 targets of USD 0.72 and -40bps respectively.
Note that back in October last year when we were strongly promoting the prospect of a sharply negative differential between the RBA cash rate and the Fed funds rate, the AUD was trading around USD 0.79 and the Australian 10 year bond rate was 50bps higher than the US 10 year bond rate. Since October last year, the US 10 year bond rate has lifted from 2.32% to 2.93% and the Australia-US 10 year bond spread has now fallen to -30bps.
However, more recently, the US 10 year bond has actually fallen from its peak in May of 3.1% despite stronger momentum in the US economy and more associated confidence around the FED’s commitment to rate hikes. A factor weighing on the bond rate is increased uncertainty on global growth as the trade war between the US and China escalates. While this is a near-term negative for our higher US bond rate view, it supports our longer-term case for a weaker AUD/ USD as demand for the USD typically increases in a risk-off environment.
Perhaps the most striking example of trade war implications and relative growth momentum is seen in equity markets which appear to be suggesting a potentially worse outcome for China than the US. After Trump formalised the first round of tariffs on China on June 15, the Shanghai Composite has fallen by 8%, taking the total retracement from January to 22%. On the other hand, the S&P 500 has continued to trend up and is now almost back to its January high.
Not surprisingly, post June 15, USD/CNH is down 6% and the AUD (often used as a proxy to short China) dropped to 0.74 USD. Yet the AUD has proven to be sticky around this level for the time being – as per our forecasts which maintain our December target of USD 0.74. This is largely explained by the out-performance of iron ore relative to the broader commodity basket with China’s environmental policies providing support for high-grade ore. But we expect higher prices to reverse next year with iron ore declining to $55/t in June 2019, while the AUD hits a low of 0.70 USD in September 2019.
While the recent sharp drop in the Shanghai Composite coincides with the intensification of the trade war discussions we have no doubt that the developments in credit markets in China are also major headwinds for the economy. Over the course of 2018 the overall Shanghai Composite has fallen by 18% whereas the Shanghai Property Composite has fallen by 26%. Reasonably the Property Index could be expected to be largely impacted by credit issues rather than broader trade concerns.