Westpac: Australian dollar still to fall in 2019

Via Westpac today:

The Australian dollar has held within a narrow range of USD0.704 to USD0.716 over the month.

Key commodity prices, particularly iron ore, have been stable over the month with spot at around US$90/t. General expectations have been for this price to adjust downwards. For example the government’s forecast for the iron ore price (fob) by March 2020 is US$55/t (Westpac expects US$74/t spot). Supporting the iron ore price has been ongoing reports from Vale of likely decommissioning of supply following the collapse of the tailings dam in Brumadinho – general expectation is that Vale will decommission around 40t of production lowering overall annual production from 400Mt to 360Mt. However markets are expecting even larger production cuts to eventuate. Another major producer, Rio Tinto, has also recently been impacted by a supply shock.

On the demand side confidence is rising in response to China’s commitment to stabilising growth through lifting credit; easing restrictions on the shadow banking sector; supporting bond issues by local governments to finance new infrastructure investment; tax cuts; and some support to housing in selective regions.

This stability at high levels for key commodity prices is providing solid support to the Australian dollar – indeed the fair value of the AUD as measured by commodity prices, is currently holding well in excess of current spot.

On the other hand interest rate differentials continue to weigh on the AUD. When on February 21, Westpac moved to forecast the RBA would cut the cash rate by 25bps in August and November this year, markets were not anticipating a cut until April next year. That pricing has now moved forward to August with 75% of a second cut priced by mid next year.

Despite the firming of the probabilities of a rate cut the AUD has remained quite stable. That probably reflects the commodity environment and the limits to the forward expectations of currency markets.

The outlook for US interest rates is also important. In March markets had been pricing in a 70% probability of a rate cut from the FOMC by year’s end. That pricing has now moved back to a more reasonable 45% although pricing is around 80% for two cuts by September 2020.

Westpac has revised its outlook for the federal funds rate. We no longer expect a late cycle rate hike at the December meeting of the FOMC. My visit to the US in February gave me little confidence that the FOMC was likely to see the need to raise rates again in this cycle. Tailwinds in 2018, including those from global growth, fiscal policy, and financial conditions, have turned into headwinds in 2019.

Confidence around the ‘stickiness’ of the core PCE inflation measure was also clear. Indeed there was a general view that the FOMC needed to be seen to be symmetric around the 2% target for core PCE inflation. A period in which it ran above 2% would be welcomed in confirming that symmetric policy stance. My concern has always been with the likely persistent lift in growth in hourly earnings (up from a 2.5% to a 3.2% annual growth rate over the last year) as the labour market remains buoyant. However there was a view that statistical research had failed to find a link between wages growth and core PCE inflation.

The concept of neutral rates had also been ‘adapted’. There was no longer a sense of ‘long term/short term’. Neutral policy depended on potential growth (around 2%) and core PCE inflation around 2%. Westpac’s, and the FOMC’s forecast for GDP growth in 2019 is around 2%, providing further comfort that rates could stay at current levels since they are now at neutral.

Equally we do not subscribe to the view that rates will be cut by the FOMC over the 2019 and 2020 time horizon. With lower mortgage rates; solid income growth; some expected upward pressure on inflation; and fiscal policy likely to be supportive, especially in the election year of 2020, a steady rate profile seems most likely.

With markets expecting rate cuts in the US and under-pricing rate cuts in Australia some further downward pressure on the AUD can be expected from the current USD0.715. But with an improving commodity price outlook we have not moved our target of USD0.68 for AUD over the course of 2019 despite the flatter profile for the federal funds rate.