The Australian dollar has been on a tear since early May, jumping nearly 7% against the US dollar to its highest level since June 2015.
It’s been a remarkable run, but one Bill Evans, Westpac’s chief economist, thinks will soon come to an end.
He says that the AUD/USD will come under substantial selling pressure next year, offering five reasons why he thinks it’ll end 2018 buying just 65 US cents.
Here they are:
US interest rates are expected to rise more than markets expect
We envisage a US rate hike by September or certainly December with two more hikes in 2018. Market pricing currently anticipates only a 50% probability of a hike by year’s end and only one further hike in 2018. While Chair Yellen noted that rates were nearing her assessment of neutral she also emphasised that she expected the neutral rate to rise over the course of the next two years or so. Overall, we expect a further 0.75% increase in the Federal funds rate over the next two years compared to market expectations of around 0.40%.
Markets have lost faith in Donald Trump being able to deliver regulatory reforms
Despite three rate hikes in December, March and June, the USD Index (DXY) has actually fallen by 2% since prior to the US election in November. DXY is actually down 7% since its peak in December last year as markets have lost confidence in prospects for reform in the US. Markets now seem vulnerable to some upside surprises.
Australian official interest rates are likely to remain unchanged until at least the end of 2018
While there is no way of assessing markets’ direct expectations for growth in Australia the fact that a 0.25% rate hike is now factored in by August next year implies that markets are expecting a much stronger growth environment in Australia than our view. We continue to expect rates to remain on hold through 2018.
Westpac is forecasting that Australian GDP will grow by 2.5% next year, below the 3.25% level currently eyed by the RBA.
The Aussie dollar is about to lose its yield advantage over the US dollar
Our expectation for the short term yield differential between Australia and the US by end 2018 is minus 0.40% compared to market expectations of plus 0.20%. We consider that, based on historical evidence, Australian rates falling below US rates will have an exponential impact on confidence in the AUD.
Consider the only previous examples of AUD short rates falling below US rates. Over the year from July 1997 when the AUD cash rate fell 0.5% below the Federal funds rate the AUD tumbled from USD 0.75 to USD 0.57. In August 1999 when AUD also fell back to 0.5% below US rates the AUD fell from USD 0.67 to USD 0.58.
Key Australian commodity prices look set to fall
Through 2018 we expect a 26% fall in the bulk commodity Index, including a 30% fall in the iron ore price. That adjustment will be underpinned by a marked slowdown in Chinese industrial demand, as the government resumes its rebalancing policies.
Evans says that he’s not particularly surprised that Aussie dollar is trading around current levels, noting that a significantly weaker profile for the Aussie “is not expected to gather momentum until the first half of 2018”.