From Bill Evans:
Over the last month the AUD has held in a range between USD0.73 and USD 0.707. That followed a sharp fall in the AUD from USD0.745 to USD 0.71 over the previous month. Westpac is retaining its target for AUD to end 2018 around USD 0.72. Further weakness is expected for the AUD through the first half of 2019, bottoming out at USD 0.70 around the middle of 2019 before recovering somewhat to USD 0.72 by end 2019.
A year ago when the AUD was trading around USD 0.80, Westpac forecast that the AUD would finish 2018 at USD 0.70. We are pleased that the market has moved broadly in line with our forecasts over that year. A key argument behind our negative view on the AUD hinged around a substantial shift in interest rate differentials between USD and AUD short term rates, a development that was not anticipated by the market.
At that time the market was priced for the RBA cash rate to be around 40 basis points above the federal funds rate by end 2018. Westpac had argued that the differential will be the reverse – that is, the federal funds rate would end 2018 around 40 basis points above the RBA cash rate. We figured that as markets began to price in our view of interest rate differentials, persistent downward pressures would emerge for the AUD.
Markets have actually moved further than we anticipated with both Westpac and market pricing pointing to a margin of 87 basis points by year’s end. That largely reflects our underestimate of the pace of FOMC tightening, since, at the time, there was still considerable uncertainty around whether the Trump Tax Cut Plan and the Fiscal Plan would get Congress approval.
Looking further out, Westpac expects the margin between the RBA cash rate and the federal funds rate to widen to 137 basis points by June next year whereas market pricing is pointing to a margin of 120 basis points.
By December 2019, markets are anticipating a differential of 124 basis points whereas Westpac is expecting the differential of 137 basis points to hold as we anticipate that the FOMC will go on hold beyond June and the RBA will remain on hold in 2019.
It is important to distinguish between the market outlook for FOMC policy and bond rates. This current blow out in bond rates is reflecting a mix of an increased risk premium and longer term FOMC views rather than a more aggressive profile for the near term federal funds rate.
Therefore we are still expecting the RBA cash rate to undershoot the federal funds rate by more than markets are pricing but not significantly so.
Consequently, unlike a year ago, we are not anticipating a further major downdraft on the AUD as a result of markets’ reassessing interest rate differentials.
Unlike interest rate differentials, there is no reliable way of assessing market expectations for the Index of prices of Australia’s commodity exports. But we agree that Australia’s Index of Export Commodities is also an important factor for the AUD.
Sensible stuff. We still think Trump will roll out more stimulus and drive the Fed higher thus AUD lower.
