FX Watch – AUD: Some headwinds

by: Georgette Boele

  • The Australian dollar has been among the best performing major currencies so far this year
  • We expect some near-term weakness in the AUD/USD
  • We expect a consolidation in EUR/AUD in the near-term, followed by a lower EUR/AUD in Q4 of 2017
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Recent developments

So far this year, the Australian dollar has been among the strongest G10 currencies. Only the euro and the Swedish krona outperformed the Australian dollar. There are several reasons for the strength of the Australian dollar. For a start, the currency tends to move in tandem with iron ore prices (one of the main export products) as the graph on the left below shows. Moreover, the widening bond yield spread between Australia and the US has also supported the Australian dollar, as well as stronger than expected economic growth in China and positive investor sentiment.

  

AUD/USD some near-term weakness…

We expect some weakness in the Australian dollar versus the US dollar in Q3 but a modest rise thereafter. For a start, we expect US yields to move higher and the yield spreads between Australia and the US to narrow. This should support the US dollar versus the Australian dollar in the near term.

Moreover, the Fed has signalled that it will continue to hike official rates this year. Financial markets price in a probability of a rate hike by 33%. We still expect another 25bp rate hike in December although the risks for no rate hike this year have risen. The Australian central bank is firmly on hold. There have been periods that financial markets started to price in a rate hike but recently they have scaled back such expectations. Australian growth data have come in better than expected and the Reserve Bank of Australia (RBA) forecasts GDP growth to increase to around 3%. The RBA also expects inflation to increase gradually as the economy strengthens. However, wage growth is low while the labour market has tightened. The RBA expects that if labour market conditions tighten further this will result in a modest increase in wage growth. Inflation currently stands at 1.9%, which is just below the inflation target for CPI of 2 to 3%. Also according to the minutes of the 1 August RBA policy meeting “members regarded conditions in the housing market and household balance sheets as continuing to warrant careful monitoring”. It is likely that the RBA is in no hurry to hike the official rate and that the hiking cycle will probably be gradual. We expect no rate hikes by the Reserve Bank of Australia this year and two 25bp rate hikes next year starting in Q1 2018.

Finally, iron ore prices will probably contribute to some weakness in AUD/USD in Q3 as the Australian dollar tends move in tandem with iron ore prices. Iron ore prices have risen above our projections for this year and next year. It is likely that the move has been too fast and some consolidation or profit taking could be among the possibility. This leaves the Australian dollar also vulnerable in the near term.

EUR/AUD consolidation followed by weakness

Although we remain positive on the euro for the coming 18 months, we think that the euro rally will run out of steam in the near term. For a start, we expect ECB President Mario Draghi to dampen expectations about early rate hikes. The ECB is concerned that tapering will trigger an early tightening of financial conditions and seems focused on tapering without triggering a tantrum. This should weigh on the euro across the board. Meanwhile, the RBA will likely slowly but surely move into the direction of a tightening cycle which we expect to begin in Q1 of 2018. Expectations about higher rates should support Australian yields and the Australian dollar. As a result, EUR/AUD will probably stabilise around 1.50 in the near-term before it starts to grind lower (strengthening of the Australian dollar versus the euro).

  

Our base case is that ECB Draghi calms down expectations about a ECB rate hike in 2018 while the RBA will already move towards higher rates in Q1 2018. This should support the AUD versus the EUR in Q4 of this year and Q1 in 2018. From that moment onwards we forecast a consolidation in EUR/AUD as we expect both the euro and the Australian dollar to strengthen versus the US dollar, because of general US dollar weakness and monetary policy expectations (ECB and the RBA).