FX Convictions update – Short AUD/USD

by: Roy Teo

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160801-FX-Conviction-Short-AUDUSD.pdf (238 KB)

In this publication: RBA likely to cut OCR by 25 bp in August followed by another 25bp in November. Target 0.73; stop loss 0.7750. We keep HUF long versus EUR, JPY long versus GBP and long NOK versus EUR on our conviction list.

RBA likely to cut OCR by 50bp to 1.25% in 2016 – negative for the AUD

We have added short Australian dollar (AUD) versus the US dollar to our FX high conviction list. We now expect the Reserve Bank of Australia (RBA) to cut the Official Cash Rate (OCR) by another 50bp to 1.25%, compared to our previous assessment of only 25bp cut this year. As this is not fully priced in by financial markets, a weaker AUD is likely as speculative long positions in the AUD are liquidated.

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In our view, core inflation is expected to remain below the RBA’s 2-3% target range in the second half of this year. Though the unemployment rate has remained below 6% since the start of this year, job growth has slowed. In fact, full time jobs have declined by 19k in the first six months of this year. We expect subdued wage growth and slower house price gains to weigh on domestic inflation. In addition, despite the recent decline in the AUD, it remains more than 1% stronger against currencies of Australia’s main trading partners since the RBA’s last monetary policy meeting on 7 June. The strength in the AUD TWI, if sustained, is likely to push tradable inflation lower and weigh on service exports, which is highly sensitive to movements in the exchange rate. Indeed, a RBA study in 2014 stated that a 10% depreciation in the AUD TWI increases service export volume by 13% and inflation by 0.25-0.5% after about 2 years. We expect a 7% appreciation in the AUD TWI since the third quarter of 2015 to have a similar negative impact on exports and inflation.

Separately, RBA deputy governor Philip Lowe will take over as governor in September. He has previously indicated that lowering the OCR on its own would lose effectiveness as it approaches the 1% level. While we acknowledge the diminishing effects of monetary stimulus, there is still more room for the RBA to stimulate the economy given the weak inflation outlook.

On the exchange rate, the recent recovery in the AUD has been supported by firmer iron ore prices and weaker USD. However we do not expect the recent optimism in iron ore to be sustainable (our year end forecast for iron ore is USD 57). It is also worth noting that interest rate differentials between Australia and the US are not supportive of the recent strength in the AUD. Our target is 0.73. We have placed a stop loss at 0.7750.

We keep in place our HUF long versus EUR, JPY long versus GBP and NOK long versus EUR

We keep our HUF long versus EUR, JPY long versus GBP and NOK long versus EUR in our high conviction views in place. For more details please refer to our FX Convictions – Short GBP/JPY, FX Convictions – Add HUF long versus EUR and FX Convictions – Positive on Norwegian Krone.

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