Home / From heavyweight to middleweight: what’s next for the AUD

From heavyweight to middleweight: what’s next for the AUD

By Matthew Peter, Chief Economist and Jimmy Louca, Senior Economist, QIC

Just a few years ago, the AUD marked itself as a new currency heavyweight by achieving and then surpassing parity with the greenback. They were great days for Australians travelling overseas and importers.

But as the much (incorrectly) quoted line says, “The past is a foreign country: they do things differently there.”

  • The story of a muscular AUD is old news. A weakening AUD is the story of now.

    In the space of two months, the Australian dollar has fallen from around US$0.94 to US$0.87. Two forces have driven the AUD lower.

    First, the slowing Chinese economy has contributed to the iron ore price falling below US$80 per metric tonne.

    Second, the ongoing US economic recovery has seen the US unemployment rate fall below the 6 per cent barrier. A stronger US economy is a tonic for the globe, but also creates complications for Australia as it raises the prospect of higher US interest rates and potentially adds downward pressure on the AUD.

    Broadly speaking, while the two forces of lower Chinese growth and US Federal Reserve (the Fed) tightening would work to push the AUD lower, they could also push the RBA official cash rate in opposite directions.

    Weaker Chinese growth lowers Australia’s terms of trade and export earnings, thereby placing downward pressure on economic activity and inflation, leading to the possibility of RBA rate cuts.

    By contrast, if Fed tightening stems from a stronger US economic outlook, the boost to global growth could be expected to be a positive for Australian economic activity and inflation and lead to possibly higher domestic interest rates.

    Several possible scenarios for AUD

    We modelled several scenarios to see what may happen to the AUD. The starting point was current consensus economic growth and monetary policy expectations, the timing for US and Australian cash rate increases (as priced in the futures market) and the current Australian/US dollar spot price (Figure 1).

    Figure 1: Consensus views on growth and monetary policy expectations

    Figure 1 
    Sources: Bloomberg, Consensus Economics (as of 5 October 2014)

    Current market pricing for the AUD at US$0.87 is consistent with 7.1 per cent Chinese real GDP growth and 3.1 per cent US real GDP growth in 2015, Fed tightening from September 2015 and RBA policy on hold throughout 2015.

    To look forward, we tested the sensitivity of the AUD/USD exchange rate and cash rate to variations in Chinese growth prospects and variations in the timing of the Fed funds tightening cycle (Figure 2). Current market pricing is shown in bold in the middle row and column.

    Figure 2: Possible AUD/USD level in varying Chinese economic scenarios

    Figure 2 
    Sources: Bloomberg, Consensus Economics, QIC

    The cell in the bottom row, middle column of Figure 2 shows the impact of a pick-up in real US GDP growth to 3.7 per cent, which would cause the Fed to bring higher interest rates forward to June, even if Chinese growth remains at 7.1 per cent. In this scenario, the AUD would fall to US$0.84 and the resulting pick-up in Australian growth and inflation would lead the RBA to raise the official cash rate by 25 basis points.

    Alternatively, the AUD could also fall to US$0.84 if 2015 Chinese growth fell by 50 basis points to 6.6 per cent, while US growth remained at 3.1 per cent and the first Fed tightening occurred in September (middle row, last column of Figure 2).

    Effects of weaker Chinese growth

    However, in a weak Chinese growth scenario, an associated fall in Australia’s terms of trade of 6 per cent would lower economic activity from 2.9 per cent to 2.5 per cent and raise the unemployment rate from 6.0 per cent to 6.5 per cent. In this weaker Chinese scenario, the RBA would lower the official Australian cash rate by 25 basis points.

    According to our modelling, if weaker Chinese growth happened to coincide with a weaker outlook for the US economy (say because of a deterioration in Euro area growth, as has been occupying investors’ minds recently) causing the US to push back its planned tightening of the Fed funds rate to December, the AUD would fall marginally to US$0.86 (top row, last column of Figure 2).

    Under this scenario, the deterioration in economic fundamentals facing the Australian economy, from weaker growth in both China and the US, would lead to a 50 basis points reduction in interest rates by the RBA.

    Intriguingly, both a downside and upside scenario for the AUD could result in the RBA keeping rates on hold.

    A downside scenario could occur where Chinese growth, for instance, falls to 6.6 per cent and the Fed brings its first tightening of US interest rates forward to June (shown in the bottom row and last column of Figure 2). In this scenario, the AUD would approach US$0.80. Despite the fall in the AUD, the RBA would keep Australian rates on hold as the weakness in Chinese growth would offset the impact of a stronger US economy.

    Possible higher AUD

    So far, all scenarios assume a lower or steady AUD. A stronger AUD is unlikely but needs to be contemplated for completeness.

    So what might drive the AUD above US$0.90?

    An upside scenario for the AUD is where Chinese growth recovers to 7.5 per cent and the Fed pushes back its planned tightening to December 2015. In this situation, shown in the top row of the first column of Figure 2, the AUD could retrace to US$0.95.

    Here, the RBA would also remain on hold. The reason being that that the stimulatory impact of the stronger Chinese economy would raise Australian growth and inflation but that would be offset by the downward pressure on growth and inflation from weaker US growth and a strong AUD.

    As ever in the currency world, surprises out of China or the US could be catalysts for abrupt market shifts.

    The more gradual the shift in market expectations, the smoother the transition in the exchange rate. The more abrupt the change, the greater the possibility the exchange rate would overshoot fair value.


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