Monday 24 April 2017 by Opinion

AUD running out of excuses to stay above 75c

High iron ore prices and the consensus view that Australian interest rates will rise have been the excuse for the AUD holding stubbornly above 75 cents against the USD. Craig’s logic says otherwise as he explains his views and makes two big calls for 2017.

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Iron ore prices remain volatile but have fallen 30% since the Chinese President stated steel production would decline.  After domestic housing prices started to slow in April, the consensus has now shifted to falling interest rates, not rising. This leaves the AUD with little excuse for holding its position above 75c, with some of the best forecasters calling for a level around 70 cents.

Iron ore down 32% since 21 February - set to fall further

In December and January we reported that the high iron ore price was likely to be temporary as:

  1. Inventories of iron ore in China were at record levels.
  2. Rising demand was at odds with China’s long term plan to cut steel production capacity.
  3. It was likely to be a response to increased credit stimulus being used by local governments keen to achieve Beijing’s GDP targets at all costs, even if that meant overproducing steel again.

In hindsight it would appear all three scenarios came into play: 

  • Inventories have indeed peaked at a record 122m tonnes and still a massive 22% above their average over the past three years
  • The President has now announced, again, that China will be cutting steel production
  • China’s first quarter GDP come in ahead of expectations with very high public sector investment 

But iron has come back down to earth, falling from US$91 to US$65 for the benchmark price as at 21 April 2017. Domestic supply of steel in 1Q17 was around double domestic demand, meaning steel producers will again look to dump excess supply on to global markets. This on top of excess inventory in ports and in mills will mean iron ore prices will probably overshoot to the downside before demand from mills stabilises.  Prices could drop as low as US$50 before stabilising to their equilibrium around US$50-US$60 a tonne.

Housing (finally) slowing

The only argument for the RBA not cutting rates at least one more time is that they do not want to be seen as fuelling the current housing market boom. Core Logic’s data for April (20 March – 20 April) showed house prices finally slowing to just 0.3% for the month, and nil in the hottest market, Sydney.  It is only one month, but with all of the cuts to investor lending, interest only loans and deep cuts to LVRs on the hottest apartment markets in Melbourne and Brisbane, it is fair to assume that the market could be peaking.  If we see another 1-2 months of low to negative price movement, the RBA could feel they can choose to cut rates without concerns of a housing bubble.

Economic data still very weak

Nothing has changed on the economic front for Australia. The RBA’s interest rate strategy, albeit tempered by specific macroeconomic concerns such as housing bubbles, is set to maximise employment while maintaining inflation within a target band of 2-3%pa. Inflation, depending upon which measure you use, is 0.8%-1.5%pa at present.  

There has been some commentary lately to suggest that if you include house prices, inflation is much higher, but capital prices have no place in a measure of consumption demand and supply.  

This is more likely a justification by the banks for their recent out of cycle interest rate increases.  Inflation is very weak in Australia primarily due to record low wage growth (wages drive around 60-70% of overall inflation). Wage growth is weak because employment is weak, despite our low unemployment rate. The lack of focus on this issue and the continued obsession with the misleading unemployment rates means that markets are constantly caught by surprise when the RBA cuts rates guidance. 

FIIG maintains view that rates are far more likely to drop than rise

While we allow independent views across FIIG’s various market professionals and researchers, most of us hold a common view that the RBA will be holding rates at 1.5%pa or cutting them, with the latter outcome more likely if housing markets cool over the next few months. 

I certainly hold this view, and in fact would go one step further to say that unless housing were to continue at the break-neck speeds of 2016, the RBA will cut late in 2017. Employment conditions are already so weak that they reflect the worst position Australia faced in the 1990s recession, and that’s before the construction sector inevitably slows in 2018/19. In my view, the only way that the RBA will hold will be if the AUD/USD level drops to near 70 cents, which would do a lot of the heavy lifting for the RBA, bringing stimulus to the education and tourism sectors just in time to cover for the drop in construction jobs.  

AUD/USD set to resume downward trend

The Australian economy peaked in 2012.  While GDP growth will continue to be high due to exports, these exports do little for the domestic economy, for incomes or for spending. This means employment, wage growth and inflation will remain depressed, leaving the RBA with a strong rationale for leaving rates around current levels for the next few years.

Forex markets are traded heavily by speculators and over very short term trades, so they won’t always respond to the big picture immediately. But as we have seen since 2014, eventually economics catches up with markets, and a correction occurs. With iron ore and housing markets cooling, at least briefly, the odds of the AUD falling soon have risen.  

I maintain my controversial view that Australian long term rates will fall in line with, possibly even below, US long term rates for the first time since the Asian crisis, and if this occurs, the AUD will fall past 70 cents against the USD, and fall against other major currencies as well.