The Australian Dollar Rises after RBA Signals it is On Course for 2019 Rate Rise

-RBA holds rates at record low of 1.5% for 24th consecutive month.

-But delivers upbeat assessment of domestic and global economies.

-Suggests RBA on course for 2019 rate rise but others less optimistic.

© Taras Vyshnya, Adobe Stock

The Australian Dollar rose Tuesday after the Reserve Bank of Australia (RBA) gave an upbeat assessment of both domestic and global economies, leaving markets undeterred from the view that it is on course to raise interest rates from their current record lows around the middle of next year.

The RBA also signalled its comfort with the current level of the Australian Dollar when Governor Philip Lowe said only that it “remains within the range that it has been in over the past two years.” This marks a departure from previous lamentations and warnings of the damage that currency strength could do to the inflation outlook.

Policymakers also appeared to upgrade their view of the Australian labour market, lowering their forecast for unemployment in two year time to 5%, from around 5.4% previously, and acknowledging a solid pace of jobs growth in recent quarters. This further tightening of the labour market is expected to "see some further reduction in spare capacity".

"A reasonable criticism of the Bank’s unemployment forecasts and rhetoric around increasing wages growth was that a low-point of 5 ¼ per cent was still comfortably above the generally accepted NAIRU for Australia of 5 per cent. With the unemployment rate staying above the NAIRU, it was questionable as to whether the expected lift in wages growth would occur," says Bill Evans, an economist at Westpac.

The RBA downgraded forecasts for inflation later this year due to "once off" factors but reiterated an earlier observation that wage pressures may be beginning to build in some parts of the economy, which is positive for the inflation outlook over the longer term.

This is important for the Aussie Dollar because the RBA has held its interest rate at a record low of 1.5% for exactly two years now, citing below-target inflation and a debt laden household sector that it says is ill-equipped to handle the pressures of higher borrowing costs. It goes almost without saying the RBA held rates at 1.5% Tuesday.

"A literal interpretation of the sentence “the central forecast is for inflation to be higher in 2019 and 2020 than it is currently” would be that the forecasts for inflation in the August Statement on Monetary Policy are set to be lifted," says Evans. " We would be surprised if the forecast for underlying inflation in either 2018 or 2019 is lifted in the August SOMP."

Australian inflation has remained below the midpoint of the RBA's 1% to 3% target for much of the last six years. Only briefly has the consumer price index rise above the 2% handle since 2012, albeit on multiple occasions, before slipping back beneath the all-important threshold soon after.

Australian inflation rose to 2.1% again during the second quarter of 2018, although markets had hoped it might reach 2.2% and it remains to be seen whether this level of price pressures will persist for very long.

The Westpac team are cautious in their outlook for Australian inflation and wary of RBA Governor Philip Lowe's optimism. The RBA will release its latest set of detailed economic forecasts on Friday.

"The Governor does not provide a convincing commentary that wage pressures can be expected to lift; the housing slowdown and the associated wealth effect will not be headwinds for the economy; any evidence that inflation pressures are likely to build; and why global developments are not pointing to some challenges for Australia. Consequently we see no reason to be persuaded to change our view that rates will remain on hold," Evans writes, in a briefing for clients.

Nonetheless, markets have been betting the RBA will raise its interest rate some time between June and August 2019, while Tuesday's statement did little to discourage this view. 

As a result, the Australian Dollar received a boost on Tuesday, rising broadly against all of its developed world rivals. The AUD/USD rate was quoted 0.51% higher at 0.7424 while the Pound-to-Aussie rate was down 0.38% at 1.7457.

"The AUD lacks any catalyst to pursue a sustained move higher, not least because the domestic data flow is uninspiring from an RBA rate hike perspective, even more so after the disappointing Q2 CPI," says Daniel Been, head of FX research at Australia & New Zealand Banking Group. "With a number of positive events, like China’s stimulus, failing to boost the AUD materially, the environment is looking increasingly challenging."

The above dynamics are important for the Australian Dollar because changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies significantly because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

The Aussie has long enjoyed support from interest rates that were typically higher than those elsewhere in the developed world, although it no longer has any interest rate advantage over the US and Canadian Dollars, while the UK-Australia yield gap is also narrowing now the Bank of England has raised interest rates twice in the last year.

The deterioration of the outlook for Aussie interest rates, at a time when the US Federal Reserve and other central banks are raising their own rates, has incentivised investors to sell the Australian Dollar in favour of buying Pounds, US Dollars and other currencies.

As a result, the Australian Dollar has fallen 5.4% against the US Dollar in 2018, 1.2% against Pound Sterling and 2.1% against the Canadian Dollar, although it has really decline by more than this given the currency had actually risen by a similar amount during the first quarter of the year. 

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