Via Bill Evans at Westpac:
The Australian dollar has been on a tear of late. Over the last month the AUD has lifted from USD0.65 to USD0.685, although overnight we received a warning that markets are not going to be a smooth ride.
That has been in line with a solid performance in the iron ore price – rising by nearly 25% from a level that we had originally expected to be vulnerable to the downside at the time.
Supply disruptions from Brazil due to the impact of the global pandemic across the country and the lift in demand for steel in China, as the industrial production and construction cycle gathers momentum, have been largely responsible for this increase in price.
Up until now we have been prepared to question that momentum- not any more. We recognise that these positive influences on the iron ore price are unlikely to fade in the foreseeable future. Global opinion is highly sceptical about Brazil’s ability and commitment to bring the virus under control. China seems determined to make up for the “lost” first quarter, particularly in construction, over the course of the remainder of 2020 – and cram twelve months’ activity into nine.
Another important factor behind the strength of the Australian dollar has been the country’s success in containing the virus which has allowed the easing of restrictions well ahead of the governments’ original timetables. In turn, this has really boosted consumer confidence.
We first saw that on May 13 (the first convincing sign that the economic outlook was turning) when the Westpac MI Consumer Sentiment Index surged by 16.4%. That has been followed by a 6.4% lift in June effectively restoring the Index to only 2% below the average level in the six months of September – February which preceded the record 20% collapse in March and April.
Despite these supportive factors the risk environment in the world economy was always going to be the defining force for the Australian dollar. In that regard markets have generally maintained their solid momentum since mid- March when the Federal Reserve “rescued” equity and debt markets with its massive intervention to boost liquidity and ease credit concerns by committing up to USD2 trillion funding across the spectrum to corporates; small business and local government.
That initiative followed earlier commitments to the repo; Treasuries and mortgage securities’ markets. In fact, highly leveraged companies have outperformed those with more moderate funding ratios.
Complemented by aggressive fiscal policy in all major developed economies (estimates of total global stimulus are now running at around USD 9 trillion) the market recovery has been spectacular. Of most importance is the clear message that central banks and governments remain committed to restoring financial and economic stability. Markets have responded accordingly.
This sentiment was further emphasised at the June meeting of the FOMC where the Committee has committed to open- ended balance sheet expansion “at least at the current pace …. over coming months”.
The encouraging evidence is now that the advanced economies are making progress in containing the virus and easing restrictions. Of course there will be disappointments and missteps (there are genuine fears for a wide spread second wave in the northern winter; the developing world is already facing a surge in new cases; and there are already reports of rising hospital admissions in some southern states in the US) but, with official sector support and reasonable caution, we consider it unlikely that a sustained reversal in confidence will eventuate this year.
Accordingly we have significantly lifted our target for the AUD by year’s end from USD0.68 to USD0.72. Over the last month we moved up our target level for the AUD by end 2020 from USD0.66 to USD0.68, implying that we had become more circumspect about the likelihood of a significant and sustained retracement of the AUD in the second half of 2020. We still expect a much less smooth uptrend in AUD in the second half of 2020.
As we have come to expect in currency markets, considerable “front loading” of underlying economic and market developments is the norm. Consequently we are “only” expecting a further net US3.5¢ net lift to follow the US12¢ lift we have seen since financial and commodity markets began their recovery in mid-March.
For 2021 we retain our consistently held expectation that a global growth recovery will support risk and boost the demand for Australia’s key exports. Less reliance on policy support and more endogenous momentum will be the hallmarks of 2021.
We are expecting global growth to lift from minus 3% (some forecasters such as OECD are now forecasting much deeper contractions of up to 6% in 2020) in 2020 to positive 5% in 2021, including a stunning 10% growth momentum in China.
So, despite the higher starting point (USD 0.72 rather than USD0.68) we are still expecting a US4¢ lift in AUD in 2021, ending the year at USD0.76.
That is around the average level of AUD since China’s industrialisation super charged commodity prices in the early part of this century. At such a level headwinds may develop for Australia’s growth rate. Recall the lessons from the commodity and AUD boom in 2009/2010 where, to the surprise of the RBA, the lift in incomes from the booming terms of trade was leaked into savings rather than spending limiting demand while the high AUD weighed on inflation and growth.
We expect the legacies from the crisis to challenge the Australian economy in 2021. Growth is forecast to lift to 3% (from minus 4% in 2020) but the unemployment rate will remain elevated at 7% The drag on demand from international travel constraints will be material given Australia’s significant reliance on immigration; tourism and foreign students. Both voluntary and regulatory social distancing will also impact activity. Supply will also be squeezed as many companies prove unable to survive through the recession period.
The Reserve Bank is already predicting that it is unlikely to be even close to achieving its targets of full employment and 2–3% inflation by the end of its public forecasting horizon of June 2022.
We have described an environment above where even greater upward pressure than our base forecast could come on to the AUD. In these incredibly uncertain times the Bank’s current growth; inflation; and employment forecasts may be optimistic.
Recall that their forecasts are based on an AUD of USD0.64.
Downside outcomes for inflation and growth, exacerbated by an over-valued AUD, may well see the Bank reassessing it’s caution towards reducing the cash rate below zero.
The RBA has stated that it believes monetary policy still works through the traditional channels of the currency; asset prices; and disposable income.
Readers will be aware that I have made the case for negative rates being part of the policy debate. In particular it seems likely that negative rates would provide considerable downside for the AUD while supporting asset prices and lowering mortgage rates.
In this current uncertain environment we must remain alert to the risks of such a policy tilt.
