Westpac: Australian dollar will fight the Fed to fall

Via Westpac:

For the FOMC, “uncertainties” now dominate

At the June meeting, the FOMC’s stance on monetary policy shifted materially. While their core view of the economy remains positive, “uncertainties” now dominate.

Beginning with the core view, it clearly remains constructive. The only real economy forecast to see material revision in June was the 2019 inflation view, which was revised down from 1.8% to 1.5%.

Arguably this revision is a consequence of (purportedly transitory) weakness in PCE inflation since the March meeting rather than fears over its future path. Supporting this view, core inflation is seen at 1.8% in 2019 (previously 2.0%) then 1.9% and 2.0% in 2020 and 2021 respectively.

There was also essentially no change in the GDP forecasts, with above-trend growth still seen across the forecast horizon. The unemployment rate forecasts meanwhile were actually marked a touch lower.

Despite these economic forecasts, that seven participants now see two cuts in the federal funds rate by year end, and another member one cut, highlights that risks are now front of mind.

Of the risks, US trade tensions with China (and others) and, more broadly, anxiety over global growth are the focus. The meeting between President Xi and President Trump at the Osaka G20 in a little over a week will therefore be crucial.

The above begs the question, why not cut now? As made clear in the press conference by Chair Powell, the reason is that the Committee want to respond to trends that are sustained, not just temporary noise.

To the extent that trade tensions have really only escalated (again) in the past month, the FOMC clearly want to gain a greater understanding of their persistence as well as the potential consequences for the US economy.

In our recent analysis of the US economy, we highlighted that, assuming trade tensions did not escalate further but uncertainty remained, business investment was likely to deteriorate. Further, we noted that employment could also be affected by current tensions.

Under said scenario, we felt a pro-active but measured approach to policy was warranted, cutting twice by year end – most likely in September and December.

From June’s communications, it seems that the FOMC are broadly aligned to this view. Very clearly though, there are considerable risks, most notably of quicker policy action.

After the Osaka G20 meeting, President Trump may well extend the 25% tariff to the remaining $300bn of US imports from China or continue to threaten to do so in the near future if he does not get his way.

Given the soft state of US investment and fragile confidence amongst business, under either scenario, the FOMC could easily justify bringing forward the first cut to July and show stronger concern over the outlook.

To see the FOMC deliver more than two cuts over the coming year however, consumption would have to weaken along with investment. While not our base view, given the surprisingly weak employment outcome of May and as wages growth now looks to be turning down, this is a risk worth watching.

Upside risks to the outlook carry a much lower probability. The one to call out is clear evidence of a resolution to US/ China tensions at the Osaka meeting. Should this occur, then near-term rate cuts would be put off.

That said, based on his actions of the past year, it seems highly unlikely that President Trump will abandon his trade agenda all together ahead of the 2020 Presidential election. Hence an easing bias would still be warranted for fear that trade tensions would emerge again.

Implications for the Australian dollar

One of the primary determinants of the Australian dollar’s value is the interest rate differential between Australia and the US. As such, the actions of the FOMC and the market’s forward expectations matter a great deal for our currency.

Since the RBA cut the cash rate on 4 June, the Australian dollar has fallen almost a cent to around USD0.69 currently. This came as the expected terminal cash rate for this cycle fell further and faster than occurred in the US for the federal funds rate.

In our view, as expectations for the RBA prove correct (two cuts by year end) but the market is disappointed by the FOMC (two cuts rather than the three the market currently sees by end-2019), the Australian dollar should continue to fall, most likely to around USD0.68 in the second half of the year.

If as we expect, two cuts from the FOMC in 2019 stabilises growth into 2020 while Australia remains weak, then a further leg lower in the Australian dollar will be seen to around USD0.66 in the first half of 2020.

In terms of the risks to this view, given the weak state of our consumer, domestic risks are against Australia. Negative global shocks are also likely to lower our currency against the US dollar given the US dollar’s safe-haven status.

To the upside however, there is of course commodity prices which remain a significant source of strength for our currency.

In recent weeks, the price of iron ore has continued to strengthen to around USD117 currently. In Australian dollar terms, that puts the commodity at a record high price, circa AUD170.

While we anticipate prices will fall to end-2020 as Brazilian supply comes back on line, progress here will be slow. As a result, the downside skew for risks notwithstanding, there is a chance the Australian dollar continues to outperform in the near term.

Comments

  1. Despite a collapse in front end rates yesterday in the Us and 100bp or rate cuts priced in over the coming year, the A$ remains very dozy. Similarly while we’ve seen gold and iron off to the races coal – met and thermal – and petroleum have been weak and my bespoke AUD commodity price index based on live pricing is only up about 0.8% month to date.

    So I’m not at all convinced by the thesis that the AUD will strengthen. Maybe downside is constrained (by Australia’s balance of payments and limited rate differentials) bit the A$ isn’t trading well.

    • Thanks Peter. Interesting.

      In terms of how Australian economic weakness might play out – if our economy starts to weaken more significantly, would that typically have an additional effect on the AUD in addition to forecast rate cuts? Eg do foreign investors flee en masse?

      Or does all that weakness only get reflected in the currency insofar as it causes the RBA to cut?

      (All else being equal in the other currencies, of course).

      • Depends on the source of weakness. If it’s purely domestic as it has been so far, then the primary channel is Australian interest rates and the impact that has on the AUD-RoW interest rate differential and that in turn impacts the relative attractiveness of holding AUD-denominated assets.

        If the source of pressure is external, say a slowdown in China feeding into a decline in commodity prices then it could have a significant effect on the terms of trade, affecting the merchandise trade balance and the current account balance. And that in turn would weigh on the AUD, all else equal.

        Absent a significant move in commodity prices, the low level of interest rates in both Australia and the rest of the world is a significant constraint on the AUD-RoW yield differential and that does limit the pressure of capital outflows. But if we do see iron ore and metallurgical coal prices fall, then the A$ could come under significant additional pressure.

  2. The Traveling Wilbur

    I guess I can’t complain about missing ASX at the Close terribly if I’m not paying to post?

  3. The Traveling Wilbur

    Hmmmm… RBA cuts rates, follows it up with Lowey Dovey guidance… and for those who haven’t noticed already America has a whole TWO days of falling DXY and the AUD is ALREADY back above .69 and on its way to .70.

    Two. Whole. Days.

    Just. Like. Mr Holes said.

    If anyone wants to know what is likely to happen should this trend continue, just read what Mr Holes said.

    Hint: it won’t involve a lower AUD. Unless China stops stimulating (which is not going to happen).

    • Last week I expressed same opinion. RBA can cut twice or three times and FED only once in the same period and AUD will most likely still jump. As long as China keep stimulating by building empty apartments to the moon. But if China decides to stimulate via different parts of its economy then AUD will collapse.

      • The Traveling Wilbur

        Yep you did. I was nodding slowly while reading it.

        Then about 36 hours later the AUD is up a cent and I’m nodding vigorously (while looking at DXY and USD/JPY rates).

    • yeborskyMEMBER

      Did you actually post that 19 hours ago? That’s fantastic. 😉

      But, seriously, the tax on up-market vehicles is already ridiculous given the reason it was introduced. Enough with the bashing of us poor, rich folk.

      • It raises revenue and the poor are exempt from the tax. Where else is the revenue going to come from.

    • They’d have to sack 12 vibrant employees to afford the extra $20k in luxury car tax.

  4. proofreadersMEMBER

    Received a Friday night email from my domestic gas retailer to tell me that basically my gas usage tariff rate will be increasing by around 10% from 1 July – how good is Straya.

    • yeborskyMEMBER

      I had advice from my supplier, AGL, today as well, bless them. I did the sums/comparisons over the past four quarters and, on that basis, it looks like a $27-$28pa increase. Your situation may be quite different but it’s not bad from my point of view.

    • Macro Afternoon is dead. Long live Macro Afternoon.

      Maybe they want us to go out into the big bad world and meet others. Have some human contact. Look into somebody’s eyes. Experience connection and try to develop a sense of empathy for those who we belittle so easily from the high horse of our couches with dinner spilt all over a singlet we haven’t removed for days.

      • The Traveling Wilbur

        Clearly another case of a username being hijacked.

        Henceforth thou shalt be known as footores (before any of your heinous propositions bear fruit) to protect less wary gentle-readers.

      • why would they want that? hell ya cant have psychos like me cracking shit jokes about me being gratetul about sh1t cxxx not shooting underarm when committing mass murder, in the land of the long whited cloud, otherwise that woulda generated real outrage.

      • TTW,
        No. It is I. Or he. Or it.
        The above image of the MB poster seems reasonable given how disempowered they are from having their job taken away by immigrants and not being allowed to do anything at all around the house by the uppity ball and chain who has gone and watched an episode of the Drum and begun to feel like they are just as capable as the wonderfully testiclled know it all who pontificates on all things geopolitical, petrochemical, realpolitkial, philosophical and political-economical. Woe is us.

      • That explains the move in gold. Whenever Chris gets sick or goes on holidays something big happens.