Australian Dollar Rises; Wages in Focus as Interest Rate Parity Looms

Modified: Tuesday, 20 February 2018 09:20 GMT
Written by: James Skinner

Higher wage growth and a lower unemployment rate were always prerequisites for an RBA rate rise but action is doubly important now that parity between Australian and US rates is looming.

The Australian Dollar climbed against its G10 counterparts during early trading in London Tuesday, extending its recent gains, after drawing support from higher commodity prices and technical factors.

Tuesday’s move came as iron ore and gas prices ticked higher while the US Dollar advanced on its developed world rivals, leaving Australia’s Dollar the sole outperformer against the greenback and other currencies.

Australia’s Dollar has risen steadily against the greenback in the last week, aided by a weak US currency and a solid January employment report, while also notching up gains over the Pound and Euro.

However, this nascent bull run could come to an abrupt end later this week if Wednesday’s fourth quarter wage price index fails to lift expectations for Australian pay growth.

“The annual growth rate in the private sector wage price index (excluding bonuses) is projected to stay at 2% (+0.5% QoQ) consistent with a benign inflation outlook,” says Elias Haddad, a senior FX strategist at Commonwealth Bank of Australia.

Wage pressures, and labour markets by implication, are the most important macroeconomic variables in the global interest rate equation at the moment given their significance for inflation.

Central banks can only raise interest rates in response to changes in inflation pressures while it’s expectations of higher or lower interest rates that dictate the respective fates of the currencies tied to them.

“Tighter Australian labour market conditions point to upside risk to wage growth. Faster wage growth (above 2%pa) can lead to an upward revision to Australian interest rate expectation in favour of AUD,” says Haddad.

The Reserve Bank of Australia held its cash rate at a record low of 1.5% for the 19th month in a row last week. Pricing in interest rate derivatives markets currently implies that rates will remain here until well into 2019.

While January's labour market report showed the 2017 Australian jobs rally continuing at the start of the New Year, the fourth quarter inflation report showed consumer price pressures are still missing in action, denting hopes of a change in the RBA's interest rate guidance in the near future.

For Australia and its Dollar, higher wage growth and a tighter labour market were always a prerequisite for markets becoming more bold in betting an interest rate hike will come sooner rather than later, but are doubly important now the gap between Australian and US interest rates is closing.

Australia’s currency has traditionally benefited from the higher yields offered by Aussie bonds relative to other developed world alternatives. But after nearly two and a half years of Federal Reserve interest rate rises, parity between Australian and US rates is looming, threatening an important source of support for the currency.

“We see no reason to change our view that the [Aussie] cash rate will remain on hold in 2018 and 2019. Early this year markets were fully priced for a hike by Dec 2018 but after the muted Q4 CPI and equity turbulence are now back to about 60% chance,” says Sean Callow, head of G10 FX strategy at Westpac.

Pricing in interest rate derivatives markets implies a 113% probability of another Federal Reserve rate hike in March. Put differently, markets are betting that an interest rate hike from the Fed in March is all but certain.

A March rate hike would put the Fed funds rate at 1.5%, neck and neck with the Australian cash rate of 1.5%, meaning the yield on US Treasury bonds could soon be higher than that offered by Aussie bonds.

“With short term implied valuations looking range bound, expect price action for the AUD/USD to follow suit pending further policy cues from the RBA this week. As such, the 0.7900 neighborhood may continue to anchor,” says Emmanuel Ng, an FX strategist with OCBC Bank in Singapore.

Tuesday’s minutes helped shed some light on policymakers’ current thinking around wages and inflation but did little to alter expectations around an initial rate hike.

The unmistakable message coming from the minutes was that wage pressures are expected to rise only at a gradual pace, leaving rate setters content to be as patient as ever before recalibrating their policy.

Ultimately, Wednesday’s wage price index will set the tone for the Aussie Dollar over coming weeks and months.

Consensus is for wages to have grown by 0.5% on average during the fourth quarter, when compared with the previous quarter, and by 2% on an annualised basis.

The AUD/USD rate was quoted 0.21% higher at 0.7926 Tuesday while the Pound-to-Australian-Dollar rate was 0.37% lower at 1.7624.

“AUD/USD is easing back following last weeks failure at the 61.8% retracement at 0.7991. A slide back below .7865 should be enough to alleviate immediate upside pressure and re-target the 200 day ma at .7773,” says Karen Jones, a technical analyst at Commerzbank.

“We continue to view the recent high at 0.8135 as an interim top. Key resistance lies at .8124/62 (the September 2017 high, the May 2015 high and the long term 50% Fibonacci retracement of the move down from 2014). Only a close above the .8162 level will introduce scope to .8295 the January 2015 high.”

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