Aussie Dollar and rates in focus

Many reasons to stay dovish on RBA and AUD. AUD rates not showing signs of QE pricing.
Philip Wee, Duncan Tan01 Oct 2019
    Photo credit: AFP Photo

    FX: Multiple reasons to stay dovish on RBA and AUD

    The Reserve Bank of Australia (RBA) is expected to lower its cash rate target by 25 bps to 0.75% today. Consensus believes that the RBA will lower rates to 0.50% in 1Q20, a level it will consider quantitative easing should the need arises. The RBA reckoned the Australian dollar would appreciate if it ignores the structural shift towards lower global interest rates. Our view remains for AUDUSD to trade into a lower 0.60-0.65 range later this year.

    When the RBA held rates steady at its last meeting on August 6, Governor Philip Lowe reckoned that the Australian economy may have reached “a gentle turning point”. Since then, real GDP growth has faltered to a decade low of 1.4% YoY in 2Q19. The economy has been reeling from the worst drought in living memory. Global growth risks, especially those pertaining to the trade war and a slowing Chinese economy, are beyond the RBA’s control. The considerable uncertainties they create have led businesses to defer investment and hiring.

    Indeed, the unemployment rate has deteriorated from 4.9% in February to 5.3% in August, back to where it was a year ago, farther from the RBA’s estimated 4.5% full-employment level. This coupled with subdued wage growth have kept a lid on consumption growth. On the supply-side, crude oil prices are well below levels a year ago. Hence, CPI inflation is set to stay below its official 2-3% target where it has been for the past year.

    AUD rates: No signs of QE pricing
    Interest around RBA's policy outlook has been rising, largely because some market participants believe Australia could be next to join the QE game. RBA has already cut 50bps in June and July and Governor Philip Lowe recently mentioned that it is "reasonable to expect an extended period of low interest rates". Of greater significance, we could be getting closer to the 0.25-0.50% level that RBA has identified as its effective lower bound, beyond which unconventional policy tools would likely be deployed.
    Based on AUD OISs, markets are pricing for the lower bound to be reached by 2Q2020. However, looking at several market indicators of QE pricing (curve slope, asset swap spreads, inflation expectations), there seems to be little conviction that RBA would do QE. We have not seen the Australian Commonwealth Government Bonds (ACGB) curve flatten to a large degree or on a sustained basis. In fact, the curve is still quite steep relative to global peers, especially in the long end (10Y and beyond). In terms of asset swap spreads, ACGBs do not look rich vs YTD ranges. Long-term inflation breakevens have also been trending lower, not higher (small uptick in September was due to US-China de-escalations, rather than QE expectations). In our view, markets would have to start pricing for QE at some point, particularly if the unemployment rate continues to move away from the 4.5% level that RBA has identified as necessary to lift wage growth and inflation.

    Philip Wee

    FX Strategist - G3 & Asia

    Duncan Tan

    FX and Rates Strategist - Asean

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