Recent Australian Dollar Gains Unsustainable say Westpac but Party Continues For Now as Commodities Get a Boost

The Australian Dollar has benefited from Treasury Secretary Mnuchin's comments on the US Dollar but Westpac suggests the good times down under may be about to end.  

The Australian Dollar has seen a parabolic rise at the start of 2018, driven by an intoxicating combination of higher commodity prices and a weaker US Dollar.

For now, the party goes on, with fresh gains for precious and industrial metals helping the Australian currency to new highs on Thursday. But one economist says the Aussie is now in danger of a double digit decline for 2018.

America’s Dollar has weakened at the same time as optimism over global economic growth has picked up, suggesting recent price action might be the result of investors chasing rising returns elsewhere. It has certainly been a significant driver of the 3.4% appreciation of the AUD/USD so far in January.

The Dollar’s woes, and Aussie’s gains, were exacerbated last week when the US government was forced into a shutdown. The greenback was clobbered again Wednesday when US Treasury secretary Steven Mnuchin appeared to endorse a weaker Dollar at the World Economic Forum in Davos.

Mnuchin's Dollar crushing comments have also helped to reverse an earlier slump in commodity prices, lifting oil benchmarks and gold while pulling industrial metals like iron ore and copper back from earlier lows.

“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin said in remarks that could, at best, be described as ambivalent toward the Dollar’s plight.

All told, recent events have served to push the AUD/USD rate close to its highest level since the middle of 2015, and a point that economists say is not justified by current Australian fundamentals.

Above: AUD/USD exchange rate shown at daily intervals.

In fact, the recent gains made by the Australian Dollar may have only served to increase the downside for the currency later in the year.

“In mid-December we expected an 8.5% fall in the AUD through 2018 to reflect a stronger USD; a benign RBA; and that 20% fall in Commodity Prices,” says Bill Evans, chief economist at Westpac.

“With the bigger increase (7% vs 5%) in the USD now expected and RBA and Commodity Price views unchanged we now expect a larger fall in AUD/USD (10%) than was the case in mid December.”

Evans and the Westpac team have revised their forecasts for US interest rates and now say the Federal Reserve will raise rates some three times in 2018, which should deliver a boost to the Dollar later in the year.

"We now see the profile for the FED as 3x25 basis point hikes in March; June; and September," Evans writes in a recent briefing, making a prediction that would take the Fed interest rate to 2.25% by the end of 2018.

Meanwhile, Westpac says the combination of an anticipated fall in commodity prices and the Reserve Bank of Australia keeping its interest rate on hold will put the Australian Dollar under pressure this year.

“We were comfortable to forecast eventual contraction in the AUD/USD 10 year bond spread to zero (from the prevailing 55 basis points) by end 2018,” says Evans.

“However that was when we expected the short end margin at –38 basis points. With that expected margin now increasing to –62 basis points we have to recognise that the spread will go negative in the second half of 2018.”

Evans and the Westpac team forecast the gap between Australian bond yields and US bond yields will begin to favour the US Dollar in 2018 as the additional yield typically offered to investors holding Aussie government bonds disappears in the face of rising US rates and a stood-pat RBA.

Above: AUD/USD exchange rate shown at weekly intervals.

Rising and falling interest rates impact on a currency by making a country a more or less attractive place for foreign investors to park their funds.

With the Federal Reserve raising rates, the RBA standing still and US bonds soon to offer more yield than their Australian counterparts, the Aussie Dollar could be in for a fairly steep fall against the greenback and other currencies later in 2018.

This is expected to drive the AUD/USD rate back down to 0.7200 by year end, from its Thursday peak of 0.8118, which implies a fall of more than 11% from current levels.

Westpac’s thesis is underpinned by an expectation that Chinese growth will slow from 6.8% in 2017 to 6.2% in 2018, and this will reduce demand for Australia’s exported commodities.

The consequent drop in demand for commodities will lead to a fall in the Australian Commodities index to a tune of around 20% in 2018.

This fall in prices and demand will impact doubly on AUD, which will weaken as a result of a slowdown in the export side of the economy that keeps growth subdued and dampens inflation.

Without a rise in inflation the Reserve Bank of Australia (RBA) will see no reason to raise interest rates in the year ahead.

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