Currency Analysis: Aussie-Dollar Outlook

5th June 2014

Macro-economy

The Australian economy didn’t implode in 2014 despite consensus views that a slowing China and a peaking mining investment boom would prove a lethal combination for the economy. In fact growth picked up since late 2013, bolstered by strong exports, rising consumption and dwelling investment. Employment growth surged with the unemployment rate finally falling in March after been on an upward trajectory since early 2012. Despite concerns that a weaker Aussie dollar and the lowest level of interest rates on record would stoke inflation, annual price growth was less than markets expected leaving the rate just within the RBA’s target range.

Australia’s exports have remained resilient despite a slowing China and further deterioration in the country’s terms of trade. Quarterly export growth has averaged 1.34% in the last two years, higher than the 10 year average of 1.0%. Australia’s trade surplus with China even increased in March, though it remained below levels seen in late 2013. A surge in exports to Japan in March ahead of the nation’s sales tax hike helped to bolster exports growth. Declines in the annual export growth are worrying signs that the economy will be unable to sustain its rate of exports as China slows or stabilises. The deviation between the value and volume of Australia’s commodity exports suggests the decline in terms of trade is already having adverse effects. Thus while export growth remains resilient, we cannot expect the sector to continue to be an area of growth in future.

Recent indicators suggest some of the air is being let out of Australia’s bubbly housing market. Monthly building approvals fell -5.4% in February and continued to decline in March. The official measure of house prices fell sharply in Q1 and a fall in annual loan growth suggest the downturn could continue. While these developments show macro-prudential measures are having some affect and will ease concerns of financial instability, it also means housing will be one less sector to offset the peaking mining investment boom. Despite ultra-low interest rates, non-mining investment has still failed to counterbalance the decline in resource sector investment.

Employment growth has put in a spectacular performance since the start of the year. The economy created 106.5 thousand jobs in the year to date, leading to the biggest single drop in the unemployment rate in March since late 2010. This corresponded with an increase in labour participation, which had been on a broad down trend since mid-2010. We are seeing the evolution of a two tier labour market in Australia between part-time and full-time workers. Part-time workers have accounted for 26% of all jobs created year to date. The pace of jobs growth will also be unable to keep pace with the influx of immigrants into the economy, suggesting labour force participation will continue to decline and there will be limited pressure on wage growth as increased supply outstrips demand. Australia’s wage cost index has declined steeply since Q4 2012, illustrating the significant spare capacity in the economy despite the stronger growth in the last two quarters.

We view Australia’s recent budget as a positive for the nation’s long-term growth. The austerity budget does not prescribe front-loaded austerity but medium-term consolidation. As Treasurer Hockey noted the budget ends the “corporate welfare system” by abolishing industry assistance programmes worth $845 million. This is balanced by abolishing carbon and mining taxes, reducing the tax burden by 1.5% for 800,000 companies. The treasury is cutting government outlays while increasing spending on investment with long-term benefits. What it means for Australians’ wallet is an increase in the top marginal rate of income tax by 2% for people earning more than A$180,000. Eligibility criteria will also be applied to state pensions, based on asset holdings and income test thresholds. Consumer confidence survey figures immediately fell in the aftermath of the budget suggesting a short-term downturn in consumption is likely. However this budget implies a light fiscal drag and overall reinforces the fiscal sustainability of the government and its triple A rating. The budget should return Australia to having the lowest debt level in the G10.

Monetary Policy

Market expectations for the RBA’s next policy move have swung wildly since the beginning of the year as employment growth outpaced expectations and the weaker Aussie dollar stoked inflation concerns. Markets moved from pricing in further cash rate cuts at the start of the year to pricing in rate hikes as inflation risk took centre stage and robust economic growth allied fears of a long-term downtrend. First quarter inflation printing below consensus in April instantly priced out some hike expectations, though the Aussie bond market suggests 17 basis points of rate hikes over the next two years are still priced in.

Australian inflation is a confluence of factors. The weaker Aussie dollar is exacerbating inflationary pressures, evident in 3.3% increase in tradable inflation since mid-2013. In contrast, non-tradable inflation, which reflects domestic inflationary factors alone, has fallen 1.2% since mid-2013 as economic slack, particularly in the labour market, presses down on price growth. This has led to a relative tug of war which has left inflation rates within the RBA’s target range. With the Aussie’s exchange rate stabilising since August, the inflationary effect of a weaker Aussie dollar should begin to fall out of the annual calculation from September, revealing a much weaker underlying inflation rate.

We maintain that at this juncture the RBA is more likely to ease than hike. There are significant threats to Australia’s economic outlook emanating from China, lower global commodity prices and a peaking mining investment boom. Considering the positive evolution of housing sector imbalances and the softer outlook for inflation, the RBA lacks an economic case to hike rates. A weaker Chinese yuan gives the RBA another reason to keep policy on hold, to try to retain its competitiveness to the Chinese market.

Our base scenario remains that the RBA will keep policy on hold given that it currently doesn’t have the economic case to lower rates either. However we don’t see the RBA hiking rates until Q1 2016, making it one of the last G10 central banks to hike.

Currency Outlook

The risks are lined up for the Aussie, the reality of a slower China, lower global commodity prices, the need to reinvent itself following the mining investment boom and the tail risk that the RBA could cut the cash target given a deterioration in the growth outlook. Despite this we believe the near term direction of the AUD is higher. Simply put we are in a carry trade environment and the Aussie is triple A carry. Investors are prepared to overlook any fundamental flaws for the high yield the Aussie offers. Aussie has the other benefit of one of the few triple A currency which is reinforced by the recent Treasury budget.

The Aussie dollar is up 5.53% since the beginning of February, in line with a recovery in a number of carry currencies including the Brazilian real, Turkish lira and South African rand. The Aussie’s oblivion to fundamentals is further reinforced by a recent decoupling from the China trade. The Aussie was traditionally how investors took on exposure to China, as close trade links meant the Aussie dollar was effectively a freely floating Chinese yuan. The Aussie now appears to be impervious to the China risk as evidenced by a breakdown in the correlation between AUDUSD and copper. We believe the Aussie dollar will continue to find support until an external factor puts an end to the current carry trade environment. Two possible catalysts include expectations for tighter US monetary policy or the ECB failing to announce QE. The timeline of markets returning to the carry trade as speculation of ECB QE first emerged suggest ECB asset purchases may have directly addressed investors’ fears about a slowdown is US asset purchases.

We see the Aussie trading to $0.94 by the end of Q2. The currency will likely come under pressure through the rest of the year as either one of the two scenarios evolve. AUDUSD will trade towards $0.88, $0.86 and $0.85 by the end of Q3, Q4 and Q1 respectively.

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