Westpac: RBA crushing economy with runaway Australian dollar

See the latest Australian dollar analysis here:

Macro Afternoon

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.

David Llewellyn-Smith
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Comments

  1. I cant see any drops in the prices of imported consumer electronics. Price rises if anything. When is the the increase in AUD supposed to kick in on imported goods.

    • DominicMEMBER

      Retailers are very slow to pass on gains from an improving FX rate. Supply chain disruptions may mean that goods at source may become more expensive so don’t hold your breath.

  2. Jumping jack flash

    With incomes officially falling – it was just a matter of time considering the rampant wage theft of late.

    The banks and RBA are going to need to work much harder to try and get the debt growing fast enough again.

    There are a few solutions, infinite NIRP is one of them.

    If we have a cash rate of -5% then mortgage rates might get as low as 0.5%. Imagine the size of the debt pile people could take on.

    My wife’s cousin told us recently that with a 25k deposit and 2 very average incomes, they were told just last week they could borrow a bit over 600k. Thats simply amazing. Unfortunately they didnt have the 25k.

    Noone should ever need to take on that much debt. It is astonishing.

    In 7 – 10 years though, with the same income and parameters the eligibility criteria will need to have been lowered so people in the same financial situation will be able to borrow 1.2 million. No risk though. Absolutely none.

    Think about that.

    • GlendaFMEMBER

      JJF, in 7-10 years time you will need to borrow 2m to get an ‘average house’. If wages do not increase, then your average household income wil need to be able to suport a mortgage of 1.6m
      How do those numbers work?
      Anybody who is buying property now and into the future will be a slave, as will the renters.
      What I can’t see happening is the investor side of the market.
      Negative gearing sounds great if you’re only getting $800 week for a $2m property and losing money by the bucket load on paper. But if you actually have to support the shortfall then life for the ordinary ‘mum and dad’ Iandlords will be tough, I don’t think they’ll be able to support that.

      • Jumping jack flash

        I agree. In 2050 it will be 10 million. How can it work? But it must work like that otherwise how does the debt continue to support house prices and deliver the expected capital gains to eliminate the systemic risk?

        Its a very simple equation even i can understand.

        There are a few solutions and some of the most obvious that dont look too far-fetched in the current environment could be NIRP, QE-backed wage subsidies, and/or tiny homes on tiny blocks.

        The current outstanding amount of mortgages in Australia is 2.4 trillion. Nobody bats an eyelid. Considering that gargantuan number that the quiet Australians need to support, there is immense capacity for government debt to grow to suppport UBI/etc to grow the debt.

        • Um – the answer is ridiculously simple.

          China.

          As much as this blog loves to bash China it has been 100% responsible for our meteoric house prices. Without Iron Ore, Coal, Students, Tourism and Agriculture to China – we would not simply be bankrupt, we would be bankrupt with average house prices around $200k (like everywhere else).

          China’s warnings are being chastised around here as “don’t tell us what to do” – which is fine for the big Chihuahua on here barking madly at the Pit Bull. But their warnings are prescient. “We will destroy your economy”.

          And they will. Its a given – tourism and students would be enough – add in coal and we are completely toast. Iron ore alone wont save us.

          All to support Donald Trump and his election strategy of being anti-China. Only country in the world to be this dumb. Not even NZ or EU are falling for it.

          House prices will be absolutely crushed – along with the AUD.

          • Jumping jack flash

            Agree in principle but the interest rate manipulation that occurred in early 2000s led to rampaging debt spending including, and largely supported by asset speculation, for the next decade, and arguably triggering the resources boom.

            The resources boom ended around the GFC. Not a coincidence.
            To fill the void we started/extended the population ponzi and all the wonderful things we still have today including more interest rate manipulation for the entire duration.

            This allowed Australia to embrace and continue the “New Economy” – the charade ecomomy, for far longer than anyone else could, as we see.

            China may well have supported us but it was and is because of the debt and that is and always will be the most important thing

          • Yeah – the low interest rates did not trigger the resources boom mate.

            Our house prices have been held aloft by Japan->China during the 1990’s- 2000’s then the CAPEX boom which saw a trillion dollars flow into our economy to build out the infrastructure for the resources boom.

            During that period Iron Ore went up to $150 insane.

            We then had a GFC collapse and our housing market was thrown open to foreigners, and locals leveraged up $1.5 Trillion in debt to support those house prices.

            The “Minsky Moment” has come and passed – the last price boom in 2019 was based around the single largest financial stimulus package in this countries history as close to $800 Billion was wiped from the Federal Budget in a tax payer largess of incredible proportions.

            Like all tax cuts – they are VERY temporary, the effects are sudden, but the hangover is forever.

            China has gone, we have gutted our tax receipts, and all we have left is a $2.5 Trillion housing debt.

            If anyone thinks this party is anything more than but a bunch of vibrants tearing the fibro-sheeting off an AirBnB in Frankston they are kidding themselves. Those blue lights aint no Disco Ball.

            ..

  3. Best strategy would be to talk about doing it but not do it, should at least provide some downside pressure on the AUD. However, it’s a slippery slope, one it’s on the agenda it becomes a possibility.

    • China is pulling out of OZ – they gave us plenty of opportunities to play on the international stage rather than being Donald Trumps Chiahuahua yapping away on his behalf for his election campaign – but no.

      China will pull out of everything Australian leaving us desperately reliant on Iron exports to China which they will then be able to control us with absolute impunity.

      Do anything they aren’t happy with – fine, we’ll turn off Ore imports for 4 months and completely crash your entire economy.

      Nice.

      Then in 2022 when Simandou comes online with their Hydrogen smelting facilities and hydrogen recycling plants at the focus of their last 5 year plan – we are completely toast.

      China’s main focus at their last 5 year meeting was removing reliance on Australia – it is just staggering how we can know this, not plan for any alternative, and then accelerate our own demise.

  4. Hill Billy 55MEMBER

    How has Bill not got the memo that tourism is a net negative for the economy because of all the Aussies who travel overseas each year. Their spend is not happening out of Australia, so no need to exchange their $AUD for foreign coin. Maybe a small part in why the $AUD is levitating.
    Coupled with the foreign students not taking jobs from our young, this pandemic has been a massive plus for the underlying economy, once we are back to work.
    Of course, Scomo will ruin all his hard work by letting the students back in!

    • …..tourism is a net negative for the economy

      Lols.

      Ok champ.

      It’s close to double the opposite direction. 9 Million inbound 4-5 million outbound.

      Not including students. Tourism and Students are number 3 and 5 on our highest value exports list.

  5. Jim's Central Banking

    “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.”

    GTFO. This kent better move to a gated community with full time armed security.

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