Bill Evans: why you can forget the rally and the Australian dollar is heading to 66 cents

Bill Evans, Westpac / YouTube

The Australian dollar has risen sharply over the past two weeks as stocks and investor risk appetite recovered. Closing the week at 0.7331 the Aussie is up around four cents or around 5.76% from the September low.

But, Westpac chief economist Bill Evans says that even though it’s currently looking strong Westpac is sticking to it’s forecasts for “the Australian dollar to finish the year around USD 0.68 and fall further to USD 0.66 in the first quarter of 2016.”

Evans says the three reasons why he still holds this view are because of the Fed, commodity prices and Australia’s “chronic external deficit.”

The first reason Evans remains bearish on the Aussie dollar is that “markets remain in denial about the Fed,” Evans said with the current market pricing of just a 25% chance of a Fed hike in December under-estimating the chance that the FOMC will move rates. He noted 13 of 17 members of the FOMC in September still thought rates will rise in 2015. “More importantly, Chair Yellen indicated publicly that she expected to raise rates by year end,” Evans added.

Evans highlights that much of the debate centres around the inflation rate in the US and the fact it is sticky below 2%. But he says all the US needs is stability in energy prices and the US dollar and inflation would “bounce back to 1.6% and, arguably, a tightening labour market could see further near term pressure on the inflation rate.” That means its important for traders to recall that:

Fed speakers have consistently argued that inflation does not need to be back at 2% to justify higher interest rates – only that there is a reasonable prospect that inflation will reach 2%. Given the extent of the moves, some stability in energy and the USD seems to be a reasonable assumption.

Evans dismisses concerns over the recent slowdown in employment growth as well.

“With the unemployment rate having fallen near to levels typically viewed as consistent with full employment, a moderation in the pace of jobs growth should not necessarily be a concern for policy makers. Much faster jobs growth is normal in the recovery phase compared to the consolidation phase,” he said.

That makes the two jobs reports before the December FOMC vitally important.

Evans says the second downward force on the Aussie dollar is the outlook for the price of iron ore. He points to actions by management which had both ramped up production and driven down production costs to maintain income from its iron ore business as a pointer to continued expansion and further downward pressure on prices from supply as “industry estimates point to both BHP-B and RIO now lowering their cost bases to $25-30 per tonne.”

On the demand side he says, “China produces 50% of the world’s steel output and 70% of that steel goes into domestic construction market.” But, even though there are signs the housing market is stabilising developers still have an overhang of apartments. That means “steel production will be flat over the next twelve months suggesting that demand will not be strong enough to absorb the likely increase in supply.”

“Weaker commodity prices and a narrowing interest rate differential with the US are a reliable combination to push the AUD lower,” Evans said.

That’s a dangerous cocktail already for the Aussie. But Evans says that “a third factor is the ugly trade deficit, which is driving a deterioration in Australia’s broader external balance, which is also a key variable in our fair value model.”

He says the “cumulative trade deficit over the last six months reached an impressive $18.4 billion. That is the largest cumulative 6-month deficit since March 2008.”

It all adds up to a falling Aussie dollar in the months ahead Evans says.

Evans concludes with a warning to Australian businesses. “The exchange rates currently prevailing represent an opportunity for Australian importers to secure US dollars at levels that we would be most surprised to see persist into 2016. For multinationals looking at tactical repatriation or profit hedging decisions, the same reasoning applies,” he said.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.