Australian Dollar Resumes Decline as Interest Rate Hawks Fly the Nest

© Chris Titze Imaging, Adobe Stock

The market appears to have become less optimistic in its outlook for Australian interest rates since Tuesday's monetary policy statement. 

The Australian Dollar resumed its decline during morning trading Tuesday as markets responded to the latest Reserve Bank of Australia monetary policy statement and a slump in December retail sales.

Australia’s central bank surprised nobody when it held the cash rate at a record low of 1.5% for the 19th month, although it left some disappointed by eschewing a more hawkish turn in its language on future interest rate rises.

A small minority of economists, including those from ANZ, TD Securities and Bank of America Merrill Lynch, have been calling for an RBA interest rate rise as soon as May.

However, while broadly positive on the Australian economic outlook, Tuesday’s statement appears to have jilted the interest rate hawks after the RBA continued to emphasise the slow and gradual manner in which wages and inflation are expected to pick up.

“We think we need to conclude that the RBA’s reference to the target band weakens our case for a May rate hike at least somewhat, without ruling it out,” says David Plank, head of Australian economics at ANZ.

Plank isn’t alone in doubting the likelihood of an interest rate rise in the near term.

Pricing in interest rate derivatives markets, which investors use to hedge against changes in interest rates, assigned a 50% probability of a rate hike in August before Tuesday’s announcement.

However, after the announcement, that implied probability had fallen closer to 30%, suggesting that the broader market has also become less optimistic in its outlook for Australian interest rates.

“Our base case is for the RBA to begin removing outsized monetary accommodation in May, but we have lost conviction on this call as some data reports have underwhelmed,” says Annette Beacher, chief Asia Pacific macro strategist at TD Securities.

Separately, but also on Tuesday, Australian Bureau of Statistics  data showed retail sales falling by 0.5% during December when compared with the previous month. This was steeper than the -0.2% decline expected by the market.

December’s retail sales data follows a disappointing fourth-quarter inflation report that left both core and headline measures of the consumer price index at 1.9%, when they had been expected to tick higher by a touch. At 1.9%, the CPI is still below the RBA’s 2% to 3% inflation target.

“There is one hurdle left to reassess our May hike base case: we need a pop in Dec qtr wages growth, released 21 February. While employment growth was very strong in 2017, wages growth has so far been slow to respond,” says TD’s Beacher.

The Australian Dollar was quoted a fraction higher at 0.7881 against the US Dollar during morning trading Tuesday but was lower against the Pound, Euro, New Zealand Dollar and Canadian Dollar. The Pound-to-Australian-Dollar rate was quoted 0.19% higher at 1.7729.

Above: Pound-to-Australian-Dollar rate shown at daily intervals.

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Morgan Stanley Makes Bearish Bet Against the Aussie  

Domestic and international economic developments, as well as recent price action in the bond market, have seen investment bank Morgan Stanley begin advocating that clients bet on a steep fall in the Australian Dollar relative to the Euro.

Embedded in the rationale for this trade is an assumption that the AUD/USD rate will also fall over the coming weeks and months, which could spell trouble for Australian Dollar relative to its other G10 rivals.

“AUD may underperform after a series of weak data releases...Inflation was also weaker than expected, which in turn should lead to continued pricing out of expectations for an RBA rate hike,” says Hans Redeker, head of G10 FX strategy at Morgan Stanley.

Both headline and core measures of inflation surprised on the downside for the third quarter, when the figures were released last Tuesday, with each remaining at 1.9% on an annualised basis.

They had been expected to tick higher by a notch but the disappointment left both measures below the midpoint of the Reserve Bank of Australia's 1% to 3% target range.

This dealt a blow to those who have been hoping the first half of 2018 would see the RBA join a growing club of central banks that are tweaking their monetary policies.

“AUDUSD has been tracking the 10y yield fairly closely and the 7bp decline after housing data points to AUD downside,” says Redeker. “AUDUSD has been tracking the 10y yield fairly closely and the 7bp decline after housing data points to AUD downside.”

The relative performance of the AUD/USD rate versus the EUR/USD rate matters for the EUR/AUD exchange rate. Just like similar equations matter for the performance of the Australian Dollar relative to all other currencies other than the US Dollar.

This is because the EUR/AUD is a foreign exchange cross rate and so, at its most basic level, is the result of a simple equation that divides the EUR/USD price by the AUD/USD price.

With the EUR/USD rate already up by some 4% for the year to date and projected to go much higher, while the AUD/USD struggles under the weight of weaker economic data, there is clear scope for the Euro-to-Australian-Dollar rate to rise during the months ahead.

“Over the long term, we see vulnerabilities stemming from high household leverage, weak productivity growth and foreign funding needs,” Redeker adds.

Morgan Stanley strategists recommend that trading clients buy the EUR/AUD rate at or around the 1.5600 level and target a move up toward 1.6500, while placing a stop loss down at 1.5200. If the taking the bet, Morgan Stanley clients will be risking 2.5% of the trade value in order to gain a potential 5.75%.   

However, the team warn that a more “hawkish RBA” is a risk to their trade thesis because if the Reserve Bank uses Tuesday's statement to hint that it could soon lift the cash rate from its current record low, then it would be akin to giving the AUD/USD a shot of adrenaline in the arm.

Australia’s central bank will announce its latest interest rate decision at 03:30 am London time Tuesday. This will be followed on Friday by the latest statement on monetary policy, which will include the bank’s assessment of the inflation outlook.

The Reserve Bank has kept the cash rate at a record low of 1.5% for 18 months in a row, citing a range of factors that are dampening the inflation outlook, including weak wage growth, moribund consumer spending and high levels of household debt that all make tighter monetary policy a challenge.

It could be worth noting that, although last Tuesday’s inflation figures disappointed the market, the core-inflation reading came in above the RBA’s own forecast of 1.75%. This could mean the central bank currently holds a more upbeat view of Australia’s inflation outlook than many give it credit for.

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Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.