If the tone of the Reserve Bank of Australia’s (RBA) November monetary policy statement is anything to go by, interest rates in Australia are going nowhere fast. And with the US Federal Reserve set to lift interest rates further in the year, that could push the Australian down by nearly 10% from its present trading level.
That’s the view of Paul Dales, Chief Australia and New Zealand Economist at Capital Economics, who says narrowing rate differentials between the US and Australia will see the AUD/USD unwind much of this years gains in the period ahead.
“If we are right in expecting the US Fed funds rate to rise above the official interest rate in Australia next year for the first time since 2001 and for only the third time since the early 1980s, then the Australian dollar could fall from .7700 to .7000 in our view,” he says.
Pointing to the chart below, Dales says the Aussie’s recent weakness — seeing it fall from above .8100 in September to .7650 today — reflects a narrowing in the two-year spread between US and Australian bond yields over the past two months.
“The recent soft retail sales and inflation figures in Australia have led the financial markets to pare back their expectations of how far the Reserve Bank of Australia (RBA) will raise interest rates next year, while the stronger news on activity and more hawkish signals from policymakers in the US have led the markets to price in more interest rate hikes from the Fed,” he says.
And with the RBA set to leave official interest rates unchanged for the foreseeable future as the US Fed lifts rates, that will likely see the spread between Australian and US two-year bond yields turn negative, eroding the yield advantage that has helped to support the Aussie in recent years.
“If we are right in expecting subdued GDP growth and below-target inflation to keep the RBA on hold for all of next year, then rate expectations in Australia may fall further at the same time that they rise in the US,” says Dales.
“By June next year, the premium of official interest rates in Australia over those in the US may have been completely wiped out.”
Along with a narrowing yield advantage, Dales says that recent buoyancy in commodity prices will also reverse, adding to the downside pressure on the commodity-linked Aussie.
“We believe the Aussie will take a further leg down as the price of Australia’s main commodity export, iron ore, falls,” he says.
“We suspect that a more sustained weakening in construction activity in China will cause the iron ore price to fall from $63 a tonne to around $50 a tonne by the end of this year.”
The AUD/USD currently trades at .7642.
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