(02/12/10) Australian Dollar Currency Outlook for Next Ten Months

In 2009, the Australian dollar was the best performer among currencies in advanced economies as the country's economy was more resilient and avoided falling in recession during last year’s global financial and economic crisis. Moreover, the Reserve Bank of Australia was the first central bank in the world that increased interest rates three times last year.

Trade-weighted AUD surged +25.3% in 2009 after plummeting -19% in the prior year. Against individual currencies, AUD surged +47% against CAD, +30.1% against JPY, +26.8% against USD, and +23.95 against EUR.

After a robust year, we expect the Australian dollar to lose it momentum in 2010 as interest rate differentials between AUD and other currencies narrow. Moreover, as the government unwinds stimulus measures, economic growth may decelerate.

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Recent Selloff Was More Severe Than Expected

The reversal of AUD's rally started in mid-January, and the decline was sharper than previously anticipated. Year to date, AUD plunged -2.16% against USD to 0.87 and -5.59% against JPY to 78.7. We believe factors catalyzing the situation were an unexpected pause in RBA tightening, earlier-than-expected tightening in China, as well as risk aversion triggered by the US bank proposal and sovereign debt crises in peripheral European countries.

The RBA surprised the market by leaving the cash rate unchanged at 3.75% at the February meeting as policymakers would like to gauge the impacts of previous rate hikes on economic development. In the accompanying statement, the RBA realized domestic lenders “Have generally raised rates a little more than the cash rate over recent months and most loan rates have risen by close to a percentage point.” In December, deputy governor Battellino said that it's “Reasonable to conclude that the overall stance of monetary policy is now back in the normal range” after lenders raised borrowing costs above their previous cyclical lows.

Moreover, earlier-than-expected cooling measures from China allowed the RBA's actions to be less aggressive. On January 12, the People's Bank of China raised the deposit reserve requirement ratio (RRR) for commercial banks by +50 bps. This signaled the government's determination to contain inflation and indicated that more cooling policies to curb lending would follow. Australia and China are close trading partners. At previous meetings, the RBA stated, “Growth in China has been very strong, which is having a significant impact on other economies in the region and on commodity markets.” Therefore, the potential slowdown in China should be affecting Australia's economy.

Market sentiment has been seriously hurt recently as the Obama administration proposed a plan to curb risk taking in banks. Moreover, Greece's budget deficit-to-GDP ratio surged to three times above EU's limit. While the Greek government submitted a three-year plan to reduce its debts, uncertainties on effectiveness and implementation remained. Worse still, contagion from Greece may engulf other European countries, evidenced in the recent surge in CDS for debts in Spain, Portugal, and Hungary.

Investors have become risk averse and have drained capital from high-yield assets to USD and JPY. According to Commitments of Traders by the CFTC, net speculative long positions in AUD have plunged dramatically over the past few weeks.

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NEXT: Monetary Policy and Economic Outlook

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Monetary Policies

The RBA was in the midst of its tightening cycle in 3Q 2007 when Australia's economic growth began to moderate. During the period, inflationary pressure was strong. Headline CPI fell below 2% y/y in 3Q 2009, but then surged rapidly to as high as 5% y/y in 3Q09. Core CPI was also elevated. The central bank kept raising the policy rate until it reached 7.25% in March 2008.

The rapid economic slowdown in 2008 and early 2009 forced the RBA to lower interest rates. The easing cycle officially began in September 2008 when the central bank announced a -25 bps cut in the cash rate. The easing process sped up after Lehman Brothers went bankrupt and the RBA reduced the cash rate by -400 bps to 3% between October 2008 and April 2009.

As the Australian economy proved to be much less affected than other developed countries, the RBA delivered the first rate hike, by +25 bps, in October 2009. Two more rate hikes in November and December, each by +25 bps, brought the policy rate to 3.75%.

Despite the unexpected pause in rate hike in February, the RBA has not ended the current tightening cycle. In February's meeting statement, the central bank said “Interest rates to most borrowers nonetheless remain lower than average. If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term,” thus indicating the upward bias in further interest rates. Consensus forecasts predict that the RBA's cash rate will reach 4.5-5% by end of 2010. What affects the currency outlook is the pace of rate hike, which in turns hinges on the inflation outlook.

After three consecutive rate hikes in late 2009, the RBA decided to wait and see the impact of previous tightening. While the RBA has turned more cautious in raising interest rates, persistently high inflation should force another rate hike in coming months. In 4Q 2009, Australia's headline CPI rose +0.5% and +2.1% on the quarterly and yearly basis, respectively. Underlying inflation also remained well above the RBA's target of 2-3%, standing at 3.4% on an annual basis. The price index for non-tradable goods rose +2.6% y/y in 4Q 2009 from +2.3% a quarter ago, indicating strong domestic price pressure. The price index for non-tradable goods rose +2.6% y/y in 4Q 2009 from +2.3% a quarter ago, indicating strong domestic price pressure.

Economic Outlook

Australia's economy recovered more rapidly than its counterparts. Although GDP contracted -0.8% q/q in 4Q 2008, it went back to the positive territory in the next quarter, technically preventing the economy from falling into recession. Although expansion moderated in 3Q 2009, probably as a result of rate hike and fiscal unwinding, growth momentum remained resilient and should pick up again in coming quarters.

At the February statement on monetary policy, the RBA upgraded its forecasts on growth and inflation for the third consecutive quarter, though the magnitude of upgrades was lower than in August and November. GDP growth is expected to reach +3.2% y/y by 4Q 2010, followed by +3.5% y/y in 4Q 2011. Headline inflation will expand +2.5% y/y in 4Q 2010 and then by +2.75% in 4Q 2011.

The latest employment report shows that the number of payrolls rose +52.7K in January, following an increase of +37.5K in the prior month. The unemployment rate fell for the third consecutive month, reaching 5.3%. An encouraging recovery in the job market should support consumer spending. We believe that the central bank's expansionary measures should not last for long.

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Although our AUD/USD forecast suggests the currency pair will be stable throughout the year, volatility cannot be ruled out as driven by policy uncertainty, not only in Australia, but all over the world. The chart below shows high inverse correlation between the aussie and the US dollar index. If USD's strength persists because of tightening by the Fed or reduction in risk appetite, AUD should risk going lower.

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