Australian Dollar Weakness Unlikely to be Sustained as Economy Gains Momentum - Strategist

The gap between Australian and US bond yields now favours the US Dollar but strategists don't expect this to cause much further headache.

The Australian Dollar is unlikely to sustain its recent weakness, according to strategists at Commonwealth Bank of Australia, as the economy remains on a solid footing and is seen gathering more momentum in the months ahead.

CBA’s statement comes after Wednesday’s GDP report pushed the Aussie currency onto the back foot, with the economy expanding by 0.6% during the third quarter, rather than the 0.7% growth expected by economists.

“There is nothing in the GDP report which suggests to us that today’s 5bpts fall in Australian two year bond yields to 1.78% or the 0.5% decline in AUD/USD should be sustained. Overall, this was a pretty good Australian GDP report,” says Richard Grace, chief currency strategist at Commonwealth Bank of Australia.

Wednesday's report took the yield-gap between Australian and US two-year bonds into negative territory, meaning that short-dated US Treasuries now offer investors more yield than their Australian counterparts.

Changes in relative yields risk further undermining a historical source of support for the Australian currency, which has traditionally benefited from the higher interest rate offered to investors who hold Australian debt.

"AUD has quickly turned from hero out-performer to under-performer, as strong retail sales and a slightly more optimistic RBA was thwarted by weaker-than-expected GDP overnight and a slump in industrial metals, most significantly Copper. This saw important resistance levels in the AUDUSD hold and leaves it vulnerable to further weakness in the short-term," says Gajan Mahadevan, a quantitative strategist at Lloyds Banking Group.

The Australian Dollar was quoted 0.27% lower at 0.7583 against the US Dollar during early trading Wednesday and the Pound-to-Australian-Dollar rate was quoted 0.22% higher at 1.7677.

“The economy expanded by 2.8% over the year to September 2017, its fastest pace in fifteen months, and in line with our estimate of potential GDP growth of 2¾%,” says Commonwealth's Grace. “The RBA is forecasting a further pick-up in GDP growth to 3.0% over the coming year, which looks very plausible.”

The Reserve Bank of Australia struck a more upbeat tone than usual in its Tuesday monetary policy statement, given an improving outlook for investment and for the labour market.

It also appeared less concerned about the strength of the currency, perhaps given its 5% fall in the last three months, in addition to coming across less concerned about the low level of Australian inflation.

Markets have since priced the first full interest rate rise in for around March 2019. The RBA has now held the Australian cash rate at 1.5% for 16 months in a row. 

“We don’t believe AUD/USD is set for significant depreciation simply because the bond spread has turned negative and may remain broadly negative for the next six-to-twelve months,” adds Grace.

The RBA and Commonwealth forecasters all suggest the Australian economy will gain further momentum during the months ahead, which could help to lift Aussie bond yields once again.

“We believe the -3bpts Australia-U.S. two-year bond spread is a considerable headwind to AUD/USD upside. But Australia’s structurally narrow current account deficit, high terms of trade, and strong trading partner growth are significant offsets,” says Grace.

Alongside this, developments in the United States will also be key to determining the near term fortunes of the Australian Dollar. 

President Donald Trump’s administration in Washington is making headway toward passing legislation for the largest tax overhaul in modern US history, which could provide a boost to the US economy in the short term.

"Although the USD is hardly free of political risks following the Senate’s approval of the Trump tax cuts, the latter has at least opened the way to a northerly drift in UST yields – and yield has had a considerable influence on the performance of AUD/USD for quite some time," says Neil Mellor, a senior currency strategist at BNY Mellon. 

To the extent that the cuts and reforms lift growth and inflation, markets may anticipate further interest rate rises from the Federal Reserve during the coming years, over and above what is already priced into bond markets.

This might pose a further challenge to the Australian Dollar if it pushes US bond yields higher and Australia's bond market doesn't keep pace.

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