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The Australian dollar has again held to a tight range this month. High and rising commodity prices provided support, but it was hard for the bulls to get too carried away as a further rate cut was delivered by the RBA and the domestic outlook remained dour. We remain of the view that the AUD will move lower to USD0.68 in late-2019, then to USD0.66 in early-2020.
Starting with commodity prices, from USD99/t at the time of our June Market Outlook (11 June), 62%fe iron ore has since rallied to near USD125/t. This has occurred as a result of both demand and supply-side factors.
On the supply side, a recovery in Brazilian supply after the Vale disaster of early 2019 is still proving difficult. Meanwhile, Chinese demand for high-grade iron ore imports has remained strong as Chinese steel production continues to shift to efficient smelters on the coast.
The above developments are clearly positives for the Australian dollar. Yet at USD0.7023, our currency is currently only modestly higher than its 11 June level of USD0.6960.
In part, this is likely due to the recent strength in iron ore being seen as temporary. Supply disruptions will be worked through in time, and while China has increased investment in response to the slowdown in growth, the stimulus to date has been measured and by no means consistent with the beginnings of a new ‘super-cycle’. While our forecast profile for iron ore from September 2019 (now USD110/t versus USD97/t in June) to March 2020 (now USD95/t versus USD92/t in June) has been raised, each of these figures is below current spot. As we roll forward then, support for the AUD from iron ore should abate, then reverse.
This trend should further aid the Australian dollar’s move lower, an outcome we expect to principally come as a result of the state of our domestic economy and the willingness of the RBA to continue to ease.
Cutting for a second consecutive month in July and remaining open to further easing (even with the cash rate at a new historic low of 1.00%) signals that the RBA is committed to doing all it can to strengthen the Australian economy.
The issue for the RBA with respect to the currency is that, until now, US rate cut expectations have neutralised the RBA’s impact on the Australian dollar. This is true both of the June/ July cuts as well as the market’s pricing of a third cut, which we see in November.
In pricing more than 100bps of cuts in total for the US (75bps by year end), we believe that the market has materially overstated the scale of the policy response necessary from the FOMC. US business investment has certainly slowed, and risks clearly remain over the outlook. But presently, US unemployment remains at record lows and a robust consumer is still supporting above-trend GDP growth overall.
This is not to say that the FOMC will not act at all. Recognising that confidence can be fickle late in an economic cycle and given global uncertainties, we believe there is cause for the FOMC to cut by 25bps in July and likely follow-up that move with another cut in October or December, depending on the data flow. But this pair of cuts should be seen as a fine-tuning exercise to insure GDP growth is sustained at or above trend rather than a full cycle of cuts to fight-off the risk of recession.
In stark contrast to the US, Australia finds itself experiencing growth materially below trend, principally as a result of a weak consumer, and with significant questions over the efficacy of policy from this point forward. As a result, while Westpac and the market’s core expectation is for one more cut, risks are heavily skewed to the downside. A further cut to 0.50% and the use of extraordinary policy tools are real possibilities.
Given the relative economic expectation of Australia against the US, along with our view on commodities, we believe that the Australian dollar will underperform the US dollar trend in the coming six months, supporting a move down to USD0.68. And thereafter that, as the US dollar trend turns, the Australian dollar will take another leg lower in early-2020 to USD0.66.
In terms of upside for the Australian dollar, apart from another iron ore surprise in the very near term, the risks look to be marginal. One point to watch however is the stance of fiscal policy. While we don’t see the Government’s tax plan as a game changer, a large infrastructure investment drive could support the economy and reduce the RBA’s need to act, thereby supporting the Australian dollar.