Morgan Stanley: 'Prepare for some weakness' in the Australian dollar

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The Australian dollar enjoyed a barnstorming start to 2017, rallying by close to 5% against the US dollar, making it the best performing G10 currency so far this year.

However, it’s not going to last, says Morgan Stanley’s FX strategy team, suggesting that it’s “now time to prepare for some weakness” citing the likelihood of a resumption of US dollar strength, a pullback in commodity prices and frailties that exist within the Australian economy.

“Recently, AUD has been supported not only by commodities and the hope for higher fiscal spending globally, but also from a weaker USD following verbal intervention from President Trump,” the bank said in a research note released late last week.

“We, however, are of the view that the USD cannot be held lower for long amidst improving data, expectations for fiscal spending and pricing in of Fed rate hikes.”

The team says that it will be watching the Fed’s Februruary meeting statement, due to arrive at 6am AEDT on Thursday, “where
a hawkish assessment of the US economy would likely set the USD on a stronger path again, in our view”.

Alongside a recovery in the US dollar, Morgan Stanley don’t expect a repeat of 2016 in terms of commodity price strength in the year ahead, suggesting that slower credit growth in China does not bode well for the Australian dollar.

“Australia’s commodity terms of trade had been supported by the surge in China’s government-driven infrastructure investment in 2016, and from supply-side capacity cuts in the mining sector,” it says, suggesting that surprise acceleration in fiscal spending from the Chinese government “not only led to a pick up in commodity import volumes from Australia, but has also caused a surge in commodity prices”.

It doesn’t expect that performance to continue in the year ahead, saying that a slowing demand outlook for China would mean the diverging relationship between China’s growth versus commodity prices will likely become more unstable.

“Should the overbought commodity market head towards a correction, AUD may lose its final pillar of support,” it says.

This chart from Morgan Stanley shows the relationship between the RBA’s commodity price index and changes in the Australian dollar trade-weighted index. The latter is lagged by three months, demonstrating that where commodity prices move, the Aussie tends to follow.

Domestically, the bank also sees frailties within the Australian economy, adding to downside risks for both Australian interest rates and the dollar.

“Local inflation continues to undershoot expectations, higher USD funding costs have started to increase the cost basis of Australia’s wholesale-backed banking sector, miners have increased their cash positions instead of investing the rising commodity revenues, and finally Australia’s overvalued housing market has the potential to trigger deflationary pressure,” the bank says, suggesting that a slowdown in housing market will push the RBA to deliver a 25 basis point rate cut in the September quarter this year.

So the US dollar will likely strengthen, commodity prices fall and the RBA will deliver a rate cut, further eroding Australia’s yield advantage over the rest of the world. It sounds like a bearish concoction for the Aussie, and Morgan Stanley firmly agrees, suggesting that the AUD/USD will fall back below the 70 cent level in the period ahead.

“We recommend short AUDUSD with a target of 0.69,” it says. “The target is in line with the AUDUSD lows seen in August 2015 after the RMB [Chinese renminbi] devaluation, and again in January 2016, which saw a sharp increase in Chinese rates.”

The AUD/USD currently trades at .7555.

AUD/USD Daily Chart

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