Beware: Australian Dollar Strength Could Force Yet Another RBA Cut

Despite cutting interest rates at their May meeting the Reserve Bank of Australia still has a fight on its hands – trying to tame a strong Australian dollar.

Australia, it is argued, needs a weaker currency to boost its non-mining economy.

Australian goods are being out-priced on global markets owing to the persistently strong AUD just at a time when the mining sector is seen as having peaked.

The outlook for the economy therefore rests with the ability of the manufacturing and services sector to pick up the slack left by a declining mining sector; global demand will be key in allowing this to transpire. 

As such, the RBA will not be happy with the current bout of appreciation that is the reaction by currency markets to their decision to cut interest rates to 2%:

• At the time of writing the British pound to Australian dollar exchange rate (GBP-AUD) has slumped to reach 1.90211.
• The euro to Australian dollar (EUR-AUD) has fallen a percent to 1.4071.
• The Australian dollar to New Zealand dollar exchange rate (AUD-NZD) has recovered to 1.0641.
• The Australian to US dollar exchange rate (AUD-USD) is half a percent higher at 0.7975.

It would appear that the reason foreign currency traders are buying the Aus dollar is because the RBA has indicated that it may not cut rates any further.

If interest rates remain stable over coming months we can see the attraction to global investors presented by steady Australian yields grow in appeal.

The flow of money to Australia is therefore likely to keep the AUD well bid.

“The balance of risks still argues for lower rates in a world flush with liquidity. Ultimately, our modest rate of growth and seemingly low level of domestic interest rates is currently very appealing to global investors,” says Warren Hogan, Chief Economist at ANZ in Sydney.

The Aussie Dollar Could be Too Strong

Governor Stevens communicated that while the Australian dollar has declined noticeably against a rising US dollar over the past year it has failed to decline materially against a basket of other currencies.

“Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices,” says Stevens.

But, “as capital flows to Australia it is unlikely that the Australian dollar will make the necessary adjustments required to support a strong recovery in non-mining investment,” argue ANZ suggesting the status quo simply won’t achieve the RBA’s aims.

So how will a weaker AUD be delivered?

It appears that the only path towards a weaker currency remains further interest rate cuts.

As such, ANZ are forecasting further cuts, but they do caution that we will have a period of stability in rates lasting at least 6 months.

This therefore suggests to us that, all being equal, the prospect of further Australian dollar gains remain viable.

Don’t Under-Estimate that Warning

Westpac have also given their response to the RBA decision and also focus on the currency’s strength.

They also focus on Governor Steven’s comments concerning the necessity of a lower exchange rate.

“This is a clear warning for FX markets that the RBA both expects and desires a weaker currency,” says Westpac’s Rob Rennie.

Could the Reserve Bank shock the currency lower in the June meeting by unleashing a completely unforeseen interest rate cut?

If this were to transpire the impact on the Australian unit would be incredibly negative simply because markets will have been caught wrong-footed.

This would also confirm that the RBA is serious about wanting a weaker exchange rate.

The Outlook According to Westpac

While we speculate that the Aussie could be shocked lower, Westpac take a more sanguine view:

“We remain of the view that AUD is in a 0.7550/ 0.8000 trading range and that strength into the 0.79/0.80 range is a sell opportunity.

“How far AUD can push higher in the short term will now depend on the guidance we get from the RBA in Friday's Statement on Monetary Policy

“Medium term, we are still forecasting lower levels for the currency. As the Australian/ US interest rate differential drops further, so will yield, issuance and demand for the A$.

“Thus we continue to expect further weakness in the A$ as the year progresses. We continue to target 0.72 by year end.”