Rates of Return
Interest rates were the primary driver behind the Aussie dollar’s run to its multi-decade highs. Though the Reserve Bank of Australia left rates unchanged for the three month period, they maintained a level of 7.25 percent. This provided a significant advantage over Japan’s 0.50 percent, the United States’ 2.00 percent, Euro Zone’s 4.25 percent and even the United Kingdom’s 5.00 percent primary rate through June. The impetus behind such an aggressive policy stance was consumer-level inflation well beyond the central bank’s 2 to 3 percent target band. The most recent round of data reported headline price pressures accelerating by a 4.2 percent annualized clip through the first quarter. Far more concerning though was the 17-year high, 4.4 percent pace of the core inflation gauge. This represents a very different dynamic than many of the other industrialized economies where inflation is largely isolated to the highly volatile goods, while core measurements are close to target.
In the months ahead, actual rate changes represent far less credible event risk than interest rate expectations. Though the cash target rate was stable at 7.25 percent over the three months through June, the market was still driven by speculation for the outcome of the next rate decision and forecasts for where rates would be in a year’s time. At the end of second quarter, credit markets were still pricing in a significant probability of another 25 basis point hike from the RBA by the end of this year. This is a dramatically different outlook than four months ago when market participants were discounting 50 basis points of easing. Helping to revive such hawkish forecasts was the RBA’s own outlook for inflation. Officials noted in both the Quarterly Monetary Policy Statement and most recent policy meeting minutes that CPI would likely hold above 4.0 percent until 2010. Realistically, these are conservative projections as gasoline and food prices are pushing to new record highs, tighter credit conditions are raising the cost of borrowing, and manufacturers are finding consumers all too willing to accept a pass through in prices. On the other hand, the market knows it won’t be as easy an equation as high inflation equals a guaranteed hike. Growth trends and the health of financial markets will play a greater role in policy and speculation for policy decisions going forward. In fact, after the July 1st rate decision, RBA Governor Glenn Stevens deemed current policy “appropriate” as the group expects “demand growth” to moderate this year and cool inflation with it gradually.
Everything Depends On Risk
While interest rates have been - and will likely continue to be - the main source for volatility in the Australian dollar, counting on such a relationship (rising interest rates leading to a stronger currency and vice versa) places considerable faith in a very big stipulation: that the carry trade will be on the rise through the third quarter. Over the previous three month period, fear surrounding the global credit crises was dying down and in turn currency market volatility settled. However, conditions are still far from ideal. While credit conditions have improved, capital markets seemed as if they are edging towards a genuine bear market as fading consumption trends and stifling inflation curb business activity globally. Though there have been periods in history where the carry trade has seen a weak or even negative correlation to risk appetite measured by more traditional investment vehicles (like equities), they have been relatively short-lived. This means that should equities topple, it will only be a matter of time before carry follows suit taking the Aussie dollar along with it.
Going forward, conditions will need to improve for the carry trade (i.e. lower volatility and a rebound in risky assets) if the AUDUSD is to have any chance at maintaining its highs – much less furthering its advance. Just at the turn of the quarter though, conditions were certainly beginning to break down. US equities fell to their lowest levels for the year and European shares pulled back to levels not seen since November of 2005. What’s more the hard-fought-for stability in the credit and general financial markets was again under threat. Ongoing write downs from major global financial firms and slowing economic growth led a number of market analysts to forecast the worst. And, even if these threats fail to materialize, rate differentials and the carry trade could still be undermined by rate changes from other currencies. Should the high Aussie’s yield hold steady, the lower yielding US, Euro Zone, Canada and UK currencies are looking at potential hikes. If yield differentials across the market deteriorate such that returns no longer compensate for risk, the carry trade and the Aussie dollar will drop.
Growth May Be A More Influential Anchor
For seventeen consecutive years, the Australian economy has posted positive growth – the longest period of expansion since World War II. No doubt, this has been one of the primary reasons for the Australian currency’s rise to multi-decade highs. However, this has been more of a passive driver for the Aussie dollar. The markets have essentially priced in strong growth through the foreseeable future. Consequently, the positive impact that further expansion could have on exchange rates has been neutralized. Alternatively, a turn in the long-standing growth trend would have a far more profound influence on the currency by changing Australia’s standing in the global rankings and dramatically altering the outlook for monetary policy in Australia. In fact, there were more than a few pieces of disappointing data in the second quarter that raised concern over the health of the economy going forward. Business sentiment was at its lowest levels since the terrorist attacks in the US back in 2001 while housing market construction was at its slowest pace in three years. Perhaps the most precarious component of growth is the consumer. Though spending was still relatively strong, confidence plunged to a 16 year low. And, while unemployment near 33-year lows and a planned A$33 billion income tax cut over the next four years will help domestic demand; the RBA has left monetary policy unchanged on expectations cooling growth would naturally rein in inflation.
Australia Still Meeting A Global Demand
Finally, a factor contributing to Australian interest rates, risk trends and domestic growth will be the ongoing strength of commodities. Representing one of the most resource-rich nations in the world, the Australian currency’s correlation to price and demand for raw materials is clear. By the end of the second quarter, supply concerns boosted orders for most basic goods (energy, metals, agricultural) to levels far beyond production capacities. This in turn developed into soaring prices. Leading the rise, crude pushed $140 per barrel while gold jumped back above $900 per ounce. Should these trends continue into the second half of the year, the impact on both Australia and the global economy could be severe. Domestically, the high price of commodities would further the central bank’s forecast for the terms of trade to grow another 20 percent year while creating new jobs and boosting wage growth. At the same time, both businesses and consumers will have to take on the burden of higher operating and living costs. For trade partners, demand may also be stunted by prices. This is already the case in the US and a number of European countries. Should orders from China fall off (especially after the Olympic building boom has passed), one of Australia’s cash cows will vanish and the true strength of the economy will be tested.
Further Gains in the Aussie Will be a Struggle
The Australian dollar was off to a strong start at the beginning of the first quarter with multi-decade highs just in sight. However, the currency may struggle to push to new highs going forward with many of its supportive trends in flux. Interest rates will once again be a deciding factor; though with the RBA suggesting it would remain on hold, rate differentials may actually work against AUDUSD. What’s more, the carry aspect of the Aussie dollar could quickly turn into a burden should another swell of risk aversion (similar to the one in the second half of last year) rise. Even staples for strength in growth and commodities could turn as it is likely only a matter of time before fading global growth trends cool the Australian economy placing downward pressure on the Aussie.
AUD/USD Technical Outlook
By Jamie Saettele
Little has changed regarding the AUDUSD. The entire rally from the 2001 low of .4775 is an A-B-C advance. Wave C has been underway since .6771 and is completing its 5th and final wave now. As long as the AUDUSD is above .9327, we maintain that wave C (from .6771) is still underway. Wave would equal wave A at .9998 (in pip terms). Wave C has taken the form of an ending diagonal (weak, overlapping structure). When ending diagonals complete, the reversal is usually sharp and the entire diagonal often retraced. Keep this in mind as the AUDUSD approaches parity. A break of the support that has contained price since August 2007 would indicate that a top is in place.