'Hawkish' RBA will Drive More Australian Dollar Strength says Capital Economics

"We expect the Aussie dollar’s outperformance against most other G10 currencies to continue" - Capital Economics.

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The Reserve Bank of Australia's quest to raise interest rates will prove supportive of the Australian Dollar, however gains will be more forthcoming against the likes of the Euro and Pound than against the U.S. Dollar.

This is according to new research from independent economics consultancy Capital Economics.

The findings come in the wake of the RBA's decision to hike interest rates by 50 basis points, a move that surprised some corners of the market that were looking for a more cautious 25-40 basis point hike.

"The RBA cited the persistent strength in inflation as the main motivation for accelerated monetary tightening, and we think policymakers will follow through with two additional 50bp rate hikes in July and August," says economist Jonathan Petersen at Capital Economics.

The Australian Dollar outperformed many other major currencies after the RBA's June interest rate decision was widely interpreted as signalling a hawkish turn in the RBA’s policy stance, leading financial markets to wager that Australia’s cash rate could top 3% later this year.

Australian Dollars were bought widely on Tuesday, leading to gains over most in the G10 and G20 buckets after the RBA took the market by surprise with a decision to lift its cash rate by a 50 basis point increment to 0.85%.

This reverses the rate cuts announced at the onset of the pandemic and was a surprise for a market that had been divided over whether the RBA would lift the benchmark by even a lesser 40 basis points.

“The decision to hike by a larger than usual 50bp indicates the Board has made the decision to front load the tightening cycle,” says Gareth Aird, head of Australian economics at Commonwealth Bank of Australia.

The RBA cited the persistent strength in inflation as the main motivation for accelerated monetary tightening.

"The central bank’s rapid shift towards tightening policy aggressively (having lagged behind many other G10 central banks until recently) is probably one reason why the Aussie dollar has fared well against the US dollar relative to other G10 currencies today, and over the course of the year," said Petersen in the wake of the RBA's decision.

"We expect the Aussie dollar’s outperformance against most other G10 currencies to continue," he adds.

Above: GBP/AUD at daily intervals.

Capital Economics see two reasons to expect ongoing outperformance:

1) The strong economic recovery in Australia continues to push up underlying inflationary pressures, which the RBA can't ignore. This contrasts favourably to those countries facing surging inflation and tepid economic growth.

2) Elevated commodity prices are traditionally a boon to the Australian economy as it is a net exporter.

A potential risk to the bullish AUD thesis would be a material decline in 'risky' assets such as stocks due to concerns about global economic growth (rather than continued monetary tightening).

"But our base case remains that the global economy will avoid recession during this tightening cycle, and that the Aussie dollar will outperform most other G10 currencies this year even as risky assets generally continue to struggle," says Petersen.