Over the last month the AUD has lifted from USD 0.705 to around USD 0.73. Markets had abruptly dumped the AUD over the previous two months. Momentum dictated that we should have extrapolated that trend and called AUD into the 60’s last month. Certainly many commentators took that option.
Westpac resisted that temptation and noted in our October Outlook, “Westpac is retaining its target for AUD to end 2018 around USD 0.72 with further weakness in the AUD through the first three quarters of 2019, bottoming out at USD 0.70 around the middle of 2019.”
However, despite the recent resurgence in AUD we are now revising down our estimate of its low point in this cycle. This is largely because we have reviewed our outlook for the US economy and US Federal Reserve policy.
We have extended our profile for interest rate increases by the Federal Reserve’s FOMC by 25 basis points. We now expect the final hike in this cycle to be September 2019 rather than June. This will see the federal funds rate peak at 3.125%.
This profile is somewhat more hawkish than current market pricing which expects the federal funds rate to peak at around 2.9% by end 2019. While the FOMC’s “dots” envisage a peak of 3.4%, this assumes a continuation of above-trend growth in 2020. We instead expect growth to decelerate to trend in late 2019.
In choosing this somewhat higher “pause point” we have studied “pauses” in the three previous tightening cycles (1995; 2000; 2006). Then the FOMC responded to a slowdown in employment growth and spending, particularly housing and durable consumer goods.
We are expecting a slowdown in employment growth through the second half of 2019 from around 1.6% at March 2019 (six month annualised) to around 1% by year’s end. Furthermore we expect the contributions to growth from housing and durables spending to decline significantly in the second half.
However our estimates indicate that with the unemployment rate settling around 3.5% in the second half of 2019 the FOMC will persevere a little longer with their gradual normalisation through 2019 before the slowdown evidence around employment; housing and durables becomes clear. Figure 1 highlights the importance of jobs growth to the timing of “pauses” while Figure 2 shows our forecasts for jobs growth and the expected timing of the pause in 2019, giving the FOMC ample time to observe the necessary slowdown.
At that key point in December 2019 when we see the FOMC pausing it will feel reasonably comfortable that it has reached a sustainable neutral setting. Inflation will be around the 2% target; growth will have slowed to near “potential” and the unemployment rate, while lower than the previously assessed “full employment” level, will not be driving excessive wage pressures.
In previous tightening cycles (see Figure 1) the labour market subsequently deteriorated sharply whereas in this cycle we anticipate that employment growth can “settle” around 1% – closely aligned with working age population growth. The FOMC will, in those circumstances, be able to hold the federal funds rate around that “neutral” level throughout 2020.
This slight change of profile for the federal funds rate has some implications for our bond and currency forecasts.
Our expected peak in the US 10 year bond rate of 3.5% has been lifted to 3.6% and been extended from June to September. The margin between the US and Australian 10 year bond rate increases from a peak of 60 basis points to 70 basis points through mid 2019.
Given this additional increase in US rates we have also extended and lifted our forecast for the USD with DXY now expected to peak near 100 by September.
For the Australian dollar, we now anticipate a further “leg down” to USD0.68 by September. The USD should then start to lose ground through the December quarter 2019 as markets detect the employment and spending slowdown and anticipate the December pause. In this way AUD would lift through the December quarter to USD0.70, lower than our previous forecast.
David Llewellyn-Smith is chief strategist at the MB Fund and MB Super which is long US equities that will benefit from a falling Australian dollar so he is definitely talking his book (or WBC is!). Below is the performance of the MB Fund since inception:
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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.
