Wednesday 28 November 2018 by Guest Contributor Opinion

AUD could be finding a base

Currency specialist Greg Gibbs reviews the weakened AUD, and forecast rate movements in Australia and the US in light of ongoing trade tensions and commodities prices


AUD could be finding a base

This year, the AUD has fallen from its high in around four years to its low in three years. The RBA started the year saying, “An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.” In November, it acknowledged that a lower AUD has helped support the economy. However, the overall movement has still been relatively contained; the range over the year-to-date is not spectacular with the AUD remaining within the same range for the last four years.

Many had thought that by now the AUD could have been a lot weaker with its yields below those in the USA by a record margin.  It seems that a further deterioration in yield spreads have contributed to weakness in the AUD this year and strength in the USD, but we may be approaching a major turning point in this spread widening. As such we could also be approaching a base in the AUD.

AUD/USD down modestly compared to record yield disadvantage

Source: Bloomberg
Figure 1

US policy delivered a shock to global markets in 2018

US fiscal and trade policy contributed to a significant shock to global markets in 2018 and led to a resurgent USD after it had fallen significantly throughout the first year of Trump’s presidency in 2017. 

Last year was characterised by synchronised global growth. This year, global divergence returned as US GDP growth and company profits were supercharged by massive tax cuts and fresh government spending. In contrast, economic and asset market performance in much of the rest of the world floundered for a variety of reasons. Higher US rates and tighter dollar funding conditions, political uncertainty, protectionist US trade policy and financial policy reforms in China have undermined global investor confidence.

Australian economy has stepped up

Despite losing momentum in the global economy, Australia’s growth has outperformed expectations this year. GDP growth rose 3.4%year over year in 2Q, a high since 2012, and unemployment has fallen from around 5.5% to 5.0%. 

The government budget position for the 2017/18 fiscal year came in $19.3bn better than initially projected, narrowing the deficit from an estimate of 1.6% of GDP to 0.6%; providing capacity for both major parties to promise more fiscal spending ahead of the election next year. 

Vulnerabilities remain for the Australian economy, but there appears to be momentum supported by infrastructure investment at the state and federal level, which is forecast to remain at a high level over coming years.  The big win by the Labor party in the Victorian state election was attributed in part to its spending on infrastructure projects and sends a message for the national election contenders.

A risk premium for global uncertainties

The AUD has fallen this year, despite its strong economic performance because the market has built in a bigger risk premium for global uncertainties. In particular, the AUD has fallen in line with weaker Chinese financial markets. Certainly, it has not helped that the Australian housing market has declined and Australian banks have been under pressure.

AUD moves with Chinese equities

Source: Bloomberg
Figure 2

The next move in Australian rates more likely to be a hike

However, the steady decline in the Australian housing market has not unduly dampened household spending.  We may be approaching the point where credit tightening in the Australian financial system related to the Hayne Royal Commission at least stabilises. Policymakers are now displaying more concern that they do not force banks to over tighten lending standards.

We may not yet be able to foresee higher Australian interest rates on the horizon, but you could at least agree with the RBA assessment that the next move is more likely to be a hike. 

US rate peak coming into view

On the other side of the coin, a peaking in US rates now seems more likely in the next year.  The tide may turn at the next US Federal Reserve monetary policy meeting towards lowering its rate projections. The currency market can be quite forward looking, and we suspect the USD could be close to a major turning point as the market looks toward a possible peaking in rates in the next year.

A crack in US financial conditions

For much of this year, the US economy and asset markets appeared impervious to global market upheaval.  This allowed Trump to roll out a more aggressive trade policy and the Fed to project a series of hikes into 2020.  However in recent months, US asset markets, from stock markets to credit spreads, are experiencing negative feedback from fears on the global economy. 

US Corporate credit spreads widen in recent months to a high since 2016

Source: Bloomberg
Figure 3

The US economy may remain robust. However, its big high tech companies are facing headwinds, the US fiscal impulse may be near a peak, negative feedback concerned with its protectionist trade policy may increase, and the fall in oil prices may dampen the now significant US energy sector. 

Having raised interest rates significantly over the last few years, the USA now has more space to ease policy if the global economy deteriorates and undermines the US economy. This can make the USD more responsive to global economic conditions than other currencies. 

It may not come to rate cuts in the US in the year ahead, but headwinds may soon pick up enough for the Fed to pause on further rate hikes for an extended period.  This could be enough to turn sentiment for the USD.

Although in light of the widening US fiscal and trade deficit a divided Congress and a combative President who is facing the Mueller probe, threatening to shut down government over border wall funding, threatening trade disputes with China and Europe, and openly criticising Fed rates policy – a levelling off in US GDP growth could be enough to turn global investor sentiment against the USD.

Commodity prices retreat

The path is not clear for a sustained revival in the AUD.  Commodity prices have fallen sharply in recent weeks. If this decline continues, it could wipe out the boost to Australian mining profits and government revenue. This could be a reflection of weaker global demand and a belated response to slowing growth in China. 

Commodity prices fall in recent weeks but remain high relative to a weaker AUD

Source: Bloomberg 
Figure 4

Trade tensions come to a head

The US-China trade dispute is approaching key events with the Xi-Trump meeting this weekend and scheduled increases in US tariffs on Chinese imports from the beginning of next year.  These events could reassert downward pressure on Chinese financial assets and commodity prices. 

For investors, the election early next year in Australia and fears over the Australian housing market may remain or become more immediate concerns.

The bigger surprise would be a rebound in AUD

However, the bigger surprise for the market at this juncture would be a reassessment of the outlook for higher US rates.  This may generate a sudden rebound in the AUD, especially if Trump opens the door to some easing of its trade dispute with China.

Key levels

The AUD has shown some tentative signs of trying to break out of a down trend in recent months.  It has at least broken out of a tight down-channel.  It managed to rise above a previous high albeit briefly at around 0.7320, and in recent weeks it has traded above its October trading range (0.7050 – 0.7160).

Source: Bloomberg
Figure 5

About Greg Gibbs
Greg is the director and founder of Amplifying Global FX Capital. He has had a long career in foreign exchange and began his career at the Reserve Bank of Australia in 1989.