Australian Dollar to Outperform as Federal Reserve Cuts Rates, Major Bank Says

Image © Desiree Caplas, Adobe Stock 

- AUD/USD to outperform as Fed cuts says Morgan Stanley.

- Fed rate cuts to offer AUD relief from bond yield pressures.

- Sees 200-day AUD/USD price average taken out this week. 

- AUD already outperforming GBP as 'no deal' Brexit fears rise.

The Australian Dollar fell Monday but is likely to outperform its other G10 rivals this week, according to analysts at Morgan Stanley, who say the Antipodean unit should "break meaningfully" above a major technical resistance barrier that blocked its way earlier in July.

U.S. Federal Reserve (Fed) officials are widely expected to call time Wednesday on the multi-year interest rate hiking cycle that helped the U.S. Dollar to best so many of its rivals last year, with consensus looking for a 25 basis point cut to take the top of the Federal Funds rate down to 2.25% on the day. 

This promises to provide the Australian Dollar with respite from the negative bond yield dynamics that have forced it down from 0.80 against the U.S. Dollar at the beginning of 2018, to just 0.69 on Monday. Those dynamics have seen Aussie bond yields go from offering international investors yields equal to those in the U.S., to offering rates that are far below those available across the pond. 

"Our economists are expecting at 50bps cut to the Fed Funds rate at the upcoming FOMC meeting. Historically, AUDUSD has been one of the top performers in the G10 space as the Fed Reserve cuts rates. Whether the Fed cuts 25bps or 50bps, we see front-end rate differentials between Australia and the US set to widen, which should help push AUDUSD higher," says Gek Teng Khoo, a strategist at Morgan Stanley. 

Changes in interest rates are normally only made in response to movements in inflation but impact currencies because of the push and pull influence they have over capital flows, and their allure for short-term speculators. Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

Above: Australian-U.S. 2-year yield-spread turns negative in January 2018.

The Fed raised rates four times back in 2018 but the analyst community now fears the trade war with China will soon begin to hurt the U.S. economy, which was always expected to slow in 2019 anway as the impact of the tax cuts from 2018 fades. Markets are betting the Fed will cut U.S. rates 0.75% in total by March 2020 as a result.

Meanwhile, the Reserve Bank of Australia (RBA) has gone from sitting on its hands to cutting Aussie interest rates aggressively, which has already seen the cash rate fall from 1.5% to 1% since the beginning of June. Investors are betting the RBA will cut the cash rate again before the year is out. 

As a result, when investors buy some bonds issued by the Australian government they now foresake close to 1% of additional interest that they would have earned had they bought U.S. government debt instead, when in January 2018 there was little difference in the two respective returns.

This change has hurt the Australian Dollar by diverting international capital flows away from Australia, but the series of interest rate cuts now anticipated from the Fed could provide the antipodean currency with some breathing room from this rate-driven downward pressure.

"Iron-ore prices are well over $100 per ton, which should improve Australia's terms of trade as well as its fiscal position. With the Treasury earmarking iron-ore prices at $52 in its latest budget, this should increase Australia's fiscal room to spend without jeopardizing the surplus. We are looking for a break meaningfully above resistance earlier this week at 0.7044 and remain long AUDUSD targeting 0.7300," Khoo writes, in a note to clients.

Above: AUD/USD at daily intervals, alonside 2-year AU-U.S. yield spread (green line, left axis). 

Morgan Stanley told clients to bet on an increase in the AUD/USD rate back in June when the exchange rate was at 0.6923 and is targeting a move up to 0.73, although the bank says the Aussie would be among the hardest hit if the Fed disappoints the market either by not cutting its rate at all, or by suggesting it might not cut as deeply in future as investors are now hoping it will. 

However, the U.S. Dollar may not be the only currency the Aussie is set for outperformance against this week because Pound Sterling was on the ropes again Monday after Michael Gove, a cabinet minister carrying the title Chancellor of the Duchy of Lancaster, wrote in the Sunday Times this week that a 'no deal' Brexit is "a very real prospect." 

He says the government hopes the EU agrees to return to the negotiating table and that it changes its mind on the so-called Northern Irish backstop, but warned the government is operating under the assumption it won't. 

Traders saw the comments implying that the threat of defaulting to doing business with the EU on World Trade Organization (WTO) has risen, prompting some to sell the British currency. Previously, the probability of such an exit was perceived to be around 30% but analysts say it's now as high as 50% and that investors will want an increased 'risk premium' in order to own the Pound. 

"Even in the unlikely scenario that Brussels is willing to reopen the Withdrawal Agreement, it is almost inconceivable that the UK government and Brussels will be able to reach a deal that could be ratified into UK law by October 31. An extension of the October 31 deadline is still possible, but in that case we cannot see any plausible result except early elections," says Stephen Gallo, European head of FX strategy at BMO Capital Markets. 

Above: Pound-to-Australian-Dollar rate shown at weekly intervals. 

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