FX comment – RBA maintains dovish view on the Australian dollar

by: Roy Teo

  • RBA maintains dovish view on the AUD
  • Lower oil prices to trigger RBA rate cut?
  • AUD to trend lower towards 0.78 in 2015

RBA maintains dovish view on the Australian dollar

As expected the Reserve Bank of Australia left monetary policy unchanged this morning and kept their forward guidance that the most prudent course is likely to be a period of stability in interest rates. The RBA’s outlook on the domestic economy remains largely unchanged from previous assessment. On the exchange rate, the RBA reiterated that the AUD remains above most estimates of its fundamental value, given the significant declines in key commodity prices in recent months. A lower exchange rate is likely needed to achieve a balanced growth in the economy.

Lower oil prices to trigger RBA rate cut?

Since the beginning of October, Brent crude oil prices have declined by more than 20% on average compared to the third quarter. Assuming full pass through of lower oil prices to automotive fuel, this could push headline inflation lower from 2.3% in Q3 to below 2% in the current quarter. Will this be a trigger for the RBA to cut rates in 2015? We do not think so for several reasons. On the commodities front, our oil strategist expects Brent crude oil to rebound next year to average around USD 90/barrel, about 10% higher than the average in the past two months. Our base metals strategist also expects iron ore prices to rebound from current level of USD 70/tonne to average around USD 90/tonne next year. On the domestic economy, housing inflation which we expect to remain relatively strong, accounts for more than 4 times of automotive fuel and urban transport fares weights in the CPI basket. Cutting interest rates will also fuel to housing market with speculative activities above the central bank’s comfort level. Though tougher bank lending practices and macro prudential tools are likely to be favored to curb house price growth, we doubt that the central bank will impose tough measures as they recognise that the strength in the housing market has been supporting household consumption despite the subdued labour market. In addition inflation expectations implied by 10y inflation link bonds have remained relatively stable around 2.3% (above the lower bound of RBA 2-3% inflation target range) since declining by 10bp as of end of September. Furthermore we expect tradable inflation to rise given the decline in the exchange rate in recent months. There are also some signs that the deterioration in the labour market has stabilised and business confidence and conditions are improving moderately.
Last but not least, the RBA’s preferred measure of inflation, the trimmed and weighted mean excludes volatile items like fruit, vegetables and automotive fuel as they often do not reflect underlying or persistent inflation pressures in the economy. In conclusion, we expect underlying inflationary pressures to remain subdued (but above 2%) in the coming months before gradually rising to above the midpoint of RBA 2-3% inflation target by the end of 2015. As such, the RBA has the flexibility to keep monetary policy unchanged at 2.5% for the rest of next year before tightening monetary policy in 2016.

AUD to trend lower towards 0.78 in 2015

In October, the AUD has failed to break above 0.89 on two attempts. This is technically negative with the bears pushing prices lower to below 0.86 in early November. Short covering and another relief rally in the AUD in the middle of November fell short at 0.88, forming a lower peak. The market is pricing in that the RBA will cut rates by 15bp within the next one year. With speculative short futures positions in the AUD at more than one standard deviation below the 10y average, the AUD could recover as rate cut bets fade in the coming months. However in our view the market is underestimating the magnitude of rate hikes in the US by more than 50bp next year, the AUD will continue to underperform the USD next year. Our 2015 year end AUD/USD forecast is 0.78.