NAB: The Australian dollar rally 'is getting ahead of itself', and that will concern the RBA

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The Australian dollar has been on a tear in early 2017.

It’s currently the best performing G10 currency worldwide, benefiting from higher commodity prices, an uplift in global economic activity and signs that the domestic economy is also on the improve.

However, despite those positives, some are now starting to question whether the renewed strength in currency is what the country needs right now, particularly after the economy suffered it’s largest quarterly contraction since the global financial crisis in the three months to September last year.

For months the RBA has suggested that a higher currency could “complicate” the Australian economy’s transition, and if recent modelling from the National Australia Bank’s FX strategy team is anything to go by, the RBA may be getting uneasy about the Aussie’s recent strength.

“A live version of our AUD RTWI [real trade-weighted index] equilibrium model suggest that the AUD RTWI has likely run ahead of itself so far in 2017, and while the equilibrium level has also risen, the rise has not been large enough to prevent the AUD RTWI from stepping back into the extremely expensive zone,” strategists at the bank wrote.

A real trade-weighed index measures changes in the Australian dollar against a basket of currencies from its largest trading partners, and adjusts for relative price levels using consumer price indices from these nations.

Pointing to the chart below, the NAB says that the Aussie RTWI is now more than one standard deviation from its equilibrium level, leaving it “extremely” overvalued.

This will make the RBA twitchy, says the NAB, especially should it be sustained.

“Recent history shows that when the AUD RTWI deviates from equilibrium on a sustained basis, then the RBA tends to become more vocal in its discomfort with the level of the currency and rate cuts have also followed shortly thereafter,” it says.

In other words, it tends to lead to “jawboning” from the RBA — talking the Australian dollar down — and, if that doesn’t succeed, it often leads to a reduction in interest rates soon after.

That’s something that few expect to arrive in the year ahead. Indeed, some are now even talking about rate hikes, not cut, within the next 12 months.

However, the NAB says its analysis suggest a case could be made for the “RBA to raise some concerns on the level of the currency”.

“Of course, under the current global political environment, talking about currencies is a delicate subject for central banks,” it says.

“Still, the AUD RTWI appears to be getting a little bit ahead of itself and although this week might be a bit too early, we think that soon enough the RBA will be compelled to voice some concerns, if not in formal statements, then in one or more upcoming speeches.

“Watch this space!,” it adds.

The National Australia Bank is now one of a handful of forecasters who still expects the RBA to cut interest rates in the year ahead, calling for two 25 point reductions before the year is out, taking the cash rate to just 1%.

The NAB remain concerned outlook for Australian GDP growth next year, largely as a result of a slowdown in housing constructions a deceleration in resource export growth.

It also thinks that the currency is an additional concern, suggesting that the benefits delivered by its prior depreciation are “probably on its last legs”.

“The currency is likely to become a drag on growth in 2018 just at a time when we expect current growth engines of housing construction and mining exports to wane,” it says.

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