Weekend Economist: Dollar dazzler

As expected the Reserve Bank Board decided to leave the cash rate unchanged at 2.5 per cent at its October meeting.

The governor also confirmed that “the most prudent course is likely to be a period of stability in interest rates”. He was also downbeat on the Australian economy forecasting below trend growth for “several quarters” and characterising the labour market as having “spare capacity” and noticeably weaker wages growth.

We expect the governor will maintain the “period of stability” assessment for some time yet until he can better gauge the underlying strength of the Australian economy (currently described by the RBA as “moderate”); whether an effective macro prudential policy can be adopted to slow investor housing; and the outlook for policy by the US Federal Reserve. He is also still not satisfied with the level of the Australian dollar. Since the last board meeting the Australian had fallen by around 6.5 per cent against the US dollar and around 4.5 per cent against the Trade Weighted Index.

Nevertheless the governor still described the currency as “high by historical standards, particularly given further declines in key commodity prices in recent months”. We expect that the governor is going to remain disappointed on this front for some time yet.

Over the six months to early September the Australian had remained firmly in a USD0.925 – 0.945 range. We were constantly required to justify our call for a target of USD0.90 by year's end with the implication that the call was overly pessimistic.

The Australian dollar has now clearly undershot our year end forecast, currently printing around USD0.88. However we are not “chasing down” the local currency. We are retaining our year's end call of USD0.90. The factors we expected to drive the fall in the Australian dollar – rising volatility; euro weakness; and a lagged response to falling iron ore prices – have all materialised with gusto.

We now need to make the case for retaining our USD0.90 year's end forecast and risk being accused of being overly optimistic. In that regard the following arguments are key.

Currency markets typically adjust rapidly to a new level and then surprise market participants looking to ‘trend follow' (a polite description for ‘naive extrapolation') by stabilising in a new range for extended periods. In the recent experience the move back to and then below 90¢ has happened more sharply than expected but our experience of market dynamics now points to a period of stability.

The catalyst for the latest drop in the Australian dollar was a sharp rise in the US dollar trend fuelled by a weakening euro as ECB President Draghi stepped up policy support just at the time when the Fed was retiring QE3. Subsequently we have seen that Draghi has been unable to satisfy market expectations and the “anticipation” trade has faded. The euro initially dropped by 5 per cent post the September ECB meeting, but following the October meeting, when Draghi's concrete actions disappointed, the euro strengthened by around 1.2 per cent. Quite possibly, the big near term move in the euro is already behind us. Indeed, we are predicting stability in EUR/USD through to year end. 

We are also forecasting that the iron ore price has bottomed out. We anticipate a lift of around 15 per cent in the price by year's end. That will be driven by a reduction in the growth in iron ore supply as we anticipate that local Chinese producers, who are already operating at costs of 10–20 per cent above the current market price, will not re-open a number of facilities after the Golden Week holiday. Recall this significant dynamic when the iron ore price last fell to around $US80/t in 2012.

In addition, the Chinese authorities have already announced a range of policy measures to boost the housing market (housing construction is the single largest user of steel) thus boosting demand. These forces are expected to gather pace through 2015, supporting a further lift of around 15 per cent in the iron ore price. While the Australian dollar has not fully adjusted to this year's 40 per cent fall, markets generally respond to surprises and are forward looking. A surprise lift is likely to see the Australian dollar outperform the broader US dollar trend going through to year's end, which we proxy by flat EUR/USD.

We expect the Australian dollar will receive further support from around March next year, chiefly due to rising fixed term interest rates in Australia and a gradually improving world outlook which will underpin higher commodity prices. While we are not anticipating a rate hike from the RBA until August next year, fixed rates are likely to be moving in anticipation of that hike by early in the June quarter.

In last week's note I contrasted our interest rate forecasts over the medium term with current market expectations. This comparison has enormous implications for the medium term path of the Australian dollar. Currently, market pricing for Australia implies rates on hold in 2015 to be followed by one single 25-basis-point hike in 2016. In contrast, US markets are forecasting 65 basis points of hikes in 2015 and 100 basis points of hikes in 2016 from the Fed.

For Australia we expect two 25-basis-point hikes in 2015 and four 25-basis-point hikes in 2016. That will be dependent on a solid lift in world growth, led by the US, particularly in 2016. A lift in world growth will boost commodity prices and, supported by attractive interest rates, the Australian dollar is expected to move back towards parity over the course of 2016. 

A good way to consider that profile is to contrast our forecasts with the recently released IMF forecasts. These showed a modest downgrade in their near term world growth forecasts. The IMF now expect 3.3 per cent in 2014; 3.8 per cent in 2015 and 4.0 per cent in 2016. Their near term forecasts are now more in line with our own forecasts of 2.9 per cent (2014) and 3.7 per cent (2015). However we have a much more optimistic forecast for 2016, expecting 4.5 per cent. 

Now contemplate current market pricing for Australia. We assess that this pricing is only consistent with a weak world economy in 2016 (in contrast with both IMF and our own forecasts). The state of the world economy will be a key consideration for the RBA when they are planning the normalisation of interest rates. That current market pricing also implies Australia hardly moves rates despite the Fed normalising rates by 165 basis points, which would imply a very weak Australian dollar. Such Australian market pricing would only be consistent with falling commodity prices and a weak world economy. The Australian dollar would be pressured back towards the low USD 80s in such circumstances – a sharp contrast to our core view. 

In summary our interest rate view is consistent with its implied view on world growth and will be critical for the expected path of the Australian dollar. The medium term path for interest rates currently implied in pricing for the Australian yield curve implies a very weak profile for the Australian dollar.

In contrast the interest rate path contained in our own forecasts points to a substantial lift in the Australian dollar through 2016.

Bill Evans is chief economist with Westpac.