GBP/AUD Rebound Supported by RBA’s Patient Approach

• GBP/AUD downtrend on cusp of a partial reversal 
• Set to hold 1.75 & may have scope to recover 1.78
• As RBA sticks with patient, data dependent stance
• BoE signals risk of a more aggressive rate policy

Image © Newtown Grafitti, Reproduced under CC Licensing.

The Pound to Australian Dollar exchange rate may be in the early stages of partially reversing a steep multi-month slide in a process that could see it better supported above the 1.75 level and possibly even breaking back above the 1.78 handle in the days or weeks ahead. 

Sterling appeared to be drawing dip-buyers from the market around the 1.75 level against the Australian Dollar early in the new week and amid price action that may have been motivated by the seemingly growing risk of a more aggressive Bank of England (BoE) interest rate policy up ahead. 

Chief economist Huw Pill reportedly told the Institute of Chartered Accountants in England and Wales on Tuesday that the BoE is willing to act “more aggressively” in order to bring down inflation in the months ahead, and even if that comes at a cost to the economy. 

This echoed the newly adopted guidance given by the BoE following June’s decision to lift Bank Rate from 1% to 1.25% and came hard on the heels of a Monday speech from Monetary Policy Committee member Catherine Mann, who also advocated for more aggressive action in the months ahead.

“The GBP remains one of our favourite shorts precisely because of the rationale that Mann lays out – the BoE is far less responsive to the inflationary shock than other central banks are,” says Bipan Rai, North American head of FX strategy at CIBC Capital Markets. 

Above: Pound to Australian Dollar rate shown at hourly intervals with Fibonacci retracements of June 16 rally indicating possible areas of short-term technical support for Sterling. Click image for closer inspection. 

“Prioritizing growth over inflation means that you have to deal with a weaker currency as well,” Rai also said on Tuesday. 

Catherine Mann argued this week that with the Federal Reserve (Fed) set to raise its interest rate aggressively in the months ahead, and potentially also the European Central Bank (ECB), Sterling would be at risk of further depreciation against the Dollar and Euro without an offset from the BoE. 

This would add further to the inflation challenge faced by the BoE and could, if taken to extremes, compel the bank to take even more aggressive and potentially damaging action at a later date. 

The seemingly more restless mood on the BoE’s Monetary Policy Committee at least appears to contrast with that of the Reserve Bank of Australia (RBA) Board, which recently voted to lift its cash rate by a larger-than-usual increment of 0.50% - leaving it at 0.85%.

“It is important that we chart our way back to an inflation rate in the 2 to 3 per cent target range,” RBA Governor Philip Lowe told the American Chamber of Commerce in Australia (AMCHAM) on Tuesday. 

Above: Australian Dollar exchange rates and performances over selected horizons. Each exchange rate forms a part of the RBA’s trade-weighted or overall measure of the Australian Dollar. Click image for closer inspection. 

“Interest rates have a role to play here, by helping ensure that spending grows broadly in line with the economy's capacity to produce goods and services. Higher interest rates can also directly affect expectations by demonstrating the commitment of the RBA to return inflation to target,” he added.

Governor Lowe did emphasise the importance of having “a credible path back to an inflation rate of 2 to 3 per cent” but later indicated that the RBA is likely to remain patient in its approach to inflation in the months ahead.

He also emphasised that RBA policy decisions will be responsive to Australian and overseas economic data while giving three reasons for why the bank sees inflation as likely to moderate of its own accord next year, ultimately helping to bring it back to within the two-to-three percent target range. 

"High inflation damages the economy, reduces the purchasing power of people's incomes and devalues people's savings. It is also regressive, hurting most those who are least well equipped to protect themselves. So it is important that we chart our way back to an inflation rate in the 2 to 3 per cent target range. We do not need to, nor can we, get there immediately," he said.

Above: Pound to Australian Dollar rate shown at daily intervals with Fibonacci retracements of February fall - induced by the Russian invasion of Ukraine - indicating possible short and medium-term areas of technical resistance for Sterling. Click image for closer inspection. 

"Australia has long had a flexible medium-term inflation target, which, by design, can accommodate deviations of inflation from target. For a number of years inflation was below target and now it is above. What is important here is that we chart a credible path back to an inflation rate of 2 to 3 per cent,” he added.

While Governor Lowe was clear that RBA interest rates are also likely to rise further in the months ahead, it's relevant that Australian inflation has been lower than in many other advanced economies and Tuesday’s remarks belied the level of concern evident in recent statements from the BoE, Fed and others.

This places a question mark over if the RBA will be likely to meet financial market expectations for a steep increase in the Australian cash rate during the months ahead, a question mark that might be likely to act as an additional headwind for the Australian Dollar in weeks ahead.

Expectations implied overnight index swaps - a form of derivative contract that can be used for hedging against, or speculating upon, changes in borrowing costs - suggest that investors and traders see the RBA’s interest rate rising much more steeply this year than those of other central banks. 

To the extent that this is the correct interpretation it would be supportive of GBP/AUD and potentially improves the prospect of it being able to recover above the 1.78 handle in the weeks ahead, which is an area of technical resistance that has stymied Sterling repeatedly this quarter.