The $A is going up again

As expectations for a Federal Reserve tightening grow, the Australian dollar has declined from a recent peak of just under US95 cents, to US93 cents now.

Not a great decline, perhaps, but it’s consistent with expectations that once the Fed tightening cycle actually begins the $A will depreciate. The consensus is still betting on an $A of circa US85 cents by year-end.

Regular Eureka Report readers will know that this has been my medium-term view on the currency as well. Not by the end of this year, mind you, but it made sense that as the interest rate gap narrowed then some of the support for the currency would subside. Nestled within that, most recently, was a tactically bullish view on the Australian dollar with a target to US95 cents – on the view that the sell-off at the time was overdone and that US95 cents would be an easy target. That proved to be the case.

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It’s at this juncture, however, and noting the recent weakness in the $A, that I’m forced to revise my medium-term bearish view on the Aussie dollar. Effectively I no longer think US80-85 cents is achievable over the medium term.

That’s not to say that I think the Fed will hold off from raising rates, nor is it to say that we won’t see some near-term weakness for the $A. The Reserve Bank of Australia will lift interest rates from their 50-year low of 2.5% at some point, and the sooner the better, although I remain sceptical about recent Fed commentary alluding to the possibility of rate hikes ‘sooner than the market expects’. Not because the US economy isn’t doing great – it is. But because Fed actions shows that it will do whatever it can to keep rates lower for longer and I’m not sure, just on the economics, why it has changed its mind all of a sudden. It’s not like US growth and job creation has just strengthened – it’s been that way for a while.

No, the main reason is because when the Fed does finally get around to tightening, the RBA is going to have to follow suit soon after. Pretty soon after I’d say, and so I don’t think the interest rate gap is really going to close at all. Three key developments are driving this:

Firstly, the housing market is rising rapidly. Recent figures from RP Data show that capital gains on dwellings were 10.2% in the year to July – with total returns closer to 15%. With the five-year cost of capital now at 4.99%, housing is a very compelling buy. Now the RBA may downplay the bubble story and I think that’s right. But it is visibly concerned about house price growth, as shown by its very public attempts at jawboning, such as the research being produced arguing it can be cheaper at times to rent rather than buy residential property (see our video, Why the RBA is wrong). The Commonwealth Treasury, for its part, is talking about lifting macro-prudential controls. None of this would be occurring if policymakers were at ease with house price growth.

Fair to say that if that was it, then it’s still unlikely in this current environment that the RBA would see much need to hike rates. Credit growth isn’t too far off recessionary levels, after all. But that’s not it. For a start, credit growth may be low, but it is rising as you can see in chart 2 below. It wouldn’t take much more of a lift in monthly growth for the RBA to start being alarmed.

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Of much more importance, the economy is stronger than expected. The mantra for years has oscillated between  ‘downturn’, ‘east-coast recession’, ‘non-mining recession’, ‘mining recession’ etc. Instead we find that the economy is currently growing at an above-trend pace and has done so comfortably for these last three years – excluding a few anomalous quarters of growth (e.g. floods etc).

Then, of course, inflation is at the top of the band on both headline and core measures. This has been one of the more unusual features of this cycle – that growth remains above trend, the unemployment rate low while, at the same time, inflation is at the top of the band – all the while the RBA sits on the lowest cash rate in a generation. It wasn’t too long ago that such metrics would have merited a much higher cash rate.

To be frank, the only thing keeping the RBA from hiking rates now is this misplaced obsession it has with the Australian dollar. Remember, we’re not talking about an interest rate stance that is neutral or even close to neutral. The RBA cash rate is the lowest in a generation, and some lending rates are the lowest on record. That’s all very well for an economy that’s gripped by a very deep recession or deflation, but we’re not.

The first chance it gets then it will hike rates, but that chance isn’t going to come, given the RBA’s effective targeting of a lower dollar, until the US Fed moves first.

Unfortunately, I can’t put any timing on this. The usual forecasting tools are useless now as the Fed’s decision isn’t an economic one. The economics scream no need for zero rates now, yet here we are. So the decision is arbitrary, but rest assured the RBA will dutifully follow suit soon after. Any weakness in the $A that we see before then will be short-lived as a result.