The Australian Dollar to Stay in Demand, but Beware Attempts by RBA to Talk Currency Lower

The Australian Dollar is likely to remain dominant for the foreseeable future but warnings continue to emerge that the Reserve Bank of Australia might soon look to clip the currency’s wings.

The AUD has rallied a massive 4% against the US Dollar over the course of the past month alone and has registered a gain of 3.16% against the Pound. Even against the mighty Euro the Aussie has held the upper hand having recorded a 1.84% advance.

The strength comes amidst supportive global economic conditions that have seen stock markets and commodity prices appreciate - two of the Aussie Dollar’s favourite conditions.

“In an environment of further improving risk sentiment, we expect commodity currencies such as the AUD to continue to be in demand,” says Manuel Oliveri at Credit Agricole.

Importantly, iron ore prices are back at $70/tonne this week which is important as this is the country’s most important foreign exchange earner.

However, there are now questions regarding the currency’s valuation as a strong currency can have the effect of slowing economic growth as exports are priced out of the global market.

And for a country like Australia which is trying to diversify away from mining this is problematic.

The Reserve Bank of Australia has already tried to quell the Aussie Dollar’s strength this July with comments from Governor Lowe and Deputy Governor Debelle both warning against market expectations for an imminent interest rate rise.

The Aussie has long benefited from Australia’s high interest rates relative to the rest of the world and this signal from the RBA will certainly have the value of the currency in its subtext.

There can be little doubt that the currency is now looking expensive.

“According to our latest estimates AUD and CAD are the most expensive currencies in the G10, while GBP and NOK the cheapest,” says Sean Callow at Westpac Bank in Sydney.

“But AUD strikes us as expensive to fundamentals. If the RBA agrees, we could see jawboning scaled up next week,” says Callow.

But, not everyone is in agreement.

"The sharp rally in AUD is unlikely to elicit much concern from the RBA yet - our model suggests the TWI is fairly valued," says Adarsh Sinha, FX Strategist at Merrill Lynch in Hong Kong.

In the Q&A session following his speech on Wednesday, RBA Governor Phillip Lowe said it would be better if the Australian dollar was a bit lower.

"We would characterise this as among the weakest attempts by th e RBA to jawbone the currency lower, but for good reason: the fact is that despite the dram atic trade-weighted appreciation in AUD during July, our latest estimate suggests the RBA's own model would show the exchange rate at close to 'fair value,'" says Sinha.

And just to reinforce this message, here is a similar take from Westpac (what's clear is that Merrill Lynch and Westpac differ in their view on how the RBA will interpret the data).

"The bottom line is there is little reason for the RBA to be overly concerned with the current level of the exchange rate. "A bit lower" is always welcome, but the RBA is unlikely to revert to the more active verbal intervention it engaged in a few years ago," says Sinha.

So if the RBA does not stand in the way of AUD appreciation, what will?

In the near term, Merrill Lynch believe there is little sto stand in the Aussie Dollar's way. 

"Domestic data surprises are positive but not extreme, the external backdrop - particularly China import demand - has remained stronger for longer, and positioning metrics are not stretched," says Sinha.

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How much further could GBP/AUD fall?

Regarding the Pound to Australian Dollar exchange rate we would certainly allow for some further declines but believe there are certainly limits when the above-mentioned threat of RBA intervention combines with a technical view of the market.

If we look at the charts we can see some pretty compelling evidence that suggests Sterling does have some significant support below which it does not tend to go.

The two green lines show previous lows - set in recent bouts of intense Sterling selling.

The levels at 1.58 and 1.5890 attracted notable buying interest on previous occasions and we would suggest that this current cycle of GBP/AUD weakness would require a massive dose of the unexpected to prompt a test below here.

Some analysts are also wary of getting too negative on Sterling noting that there is a cocktail of uncertainty ahead - yes, typically uncertainty is negative for a currency but don’t forget the potential for positive outcomes.

Indeed, analysts at Credit Suisse have upgraded their forecasts for the Euro against the Dollar but declined to do so against the Pound citing the potential for good news on Brexit to support the Pound.

Sentiment towards Sterling is so one-way at present the impact of a positive surprise could be significant.