FX Comment – AUD/USD sold aggressively to below 0.77 after RBA cuts OCR by 25bp

by: Roy Teo

  • RBA cuts OCR by 25bp to 2.25%
  • Monetary policy and AUD outlook

RBA cuts OCR by 25bp to 2.25%

In line with our expectations, the Reserve Bank of Australia (RBA) decided to lower the cash rate by 25bp to 2.25%. The decision was due to a combination of lower energy prices which will lower inflation temporarily and lower commodity prices. Economic growth continues to be below trend pace and domestic demand remains weak. Though the decline in energy prices will support consumer spending, lower key commodity export prices will also reduce income growth. Hence, the output gap will remain negative for longer than envisaged and the unemployment rate¬†will peak higher than previously forecasted. Looking ahead, inflation is expected to remain with the 2-3% target over the next one to two years, even with a lower exchange rate. The RBA also stated that they are working with other regulators to assess and contain economic risks arising from the housing market. On the exchange rate the RBA reiterated that the Australian dollar (AUD) remains above most estimates of its fundamental value given the significant declines in key commodity prices. Indeed Australia’s key commodity export prices have declined by about 20% since the beginning of 2014. On the other hand, the AUD has only declined by 11% against its trade weighted basket of currencies during the same period. Inflation expectations implied by 10y breakeven rates has also declined by about 50bp to slightly above 2% in the past year. As market consensus was expecting the RBA to keep monetary policy unchanged this morning, the AUD/USD was sold aggressively from 0.78 to below 0.7670 after the announcement.

Monetary policy and AUD outlook

In our view the full effects of previous rate cuts have largely filtered through the economy since the RBA paused its monetary easing cycle in August 2013. Hence, we maintain our view that another 25bp of rate cut by the middle of this year is needed as we expect the sharp declines in Australia’s key commodity export prices to weigh on economic growth. The rebalancing of the economy from mining to non-mining sectors will be more challenging in our view. The decline in crude oil will also impact LNG investment projects. We also maintain our view that tougher bank lending practices and other macro prudential tools will be implemented to cool investors’ speculative activities in the housing market. After the RBA announcement this morning, financial markets have quickly adjusted to our view that another 25bp rate cut is necessary in the coming months. Though we do not rule out further selling pressure in the AUD when European markets open later, we think that some consolidation above 0.76 could materialise given that technical indicators imply that the currency is at the most oversold territory since the global financial crisis in late 2008. Nevertheless, we continue to expect a lower AUD/USD towards 0.72 by the end of this year as the market is still underestimating the timing and pace of rate hikes in the US in our view.