Financial markets are are not adequately pricing the risk of an increase in US interest rates next month, and along with continued concerns about China’s economy and its currency, it will weigh on the Australian dollar even more than what was first envisaged.
That’s the bearish Aussie view offered by the NAB’s FX strategy team in a note out today, with the bank lowering the outlook for the Australian dollar against both its US and New Zealand equivalents.
The bank believes “the market is not pricing the Fed’s expected September hike adequately”, suggesting that uncertainty over whether or not the US Federal Reserve will begin normalising interest rates at its September FOMC meeting is “holding the USD back in the interim”.
The NAB believe as markets “head closer to September’s FOMC, that a full hike will be priced in and further compress Australia’s yield advantage”. This, coupled with the likelihood that the RBA are on hold until the end of 2016 in the NAB’s opinion, will see the yield advantage that Australia enjoys over the US will “continue to be eroded”.
The chart below shows the relationship between the AUD/USD spot rate in red compared to the two-year yield differential between Australia and the US in black. While the relationship between the two is not perfect, should the gap between Australian and US two-year interest rates continue to narrow, it may place further pressure on the Aussie.
Aside from a likely narrowing in Australia’s yield advantage over the US, the NAB also believe that risks to Chinese economic growth – something the bank believes are “at risk to the downside” – may weigh on commodity prices, and therefore the Australian dollar.
Here’s the NAB:
“With commodity prices weakening, as estimates for China’s growth are considered at risk to the downside, post the devaluation of the CNY, there are risks to the AUD. Australia’s terms of trade are dominated by iron ore and coal at present. NAB estimates that these will experience further modest declines in price through the forecast horizon. As the volume of LNG exports rise, so too will its influence on the terms of trade. The estimates for this commodity are also showing some downside. While an increase in export volumes is anticipated, the prices are the main determinant of the influence on the exchange rate.
If there are further concerns that China’s growth is under pressure, that will bias these prices to the downside, and so too the AUD. Post China’s CNY devaluation, Asian FX is weaker; given the relationship between AUD and regional currencies, we are factoring that additional negative pressure”.
While the NAB believes that an increase in Australian dollar short positions recently makes the grounds for future weakness “somewhat limited”, the sharp decline in the AUD/USD exchange rate last week to the low 72 cent region “shows the bias of the currency”.
As a result the bank now sees the Australian dollar falling to 0.7000 against the US dollar by the end of 2015, down from 0.7200 seen previously. Beyond that, the bank believes the AUD/USD will eventually bottom out at .6800 in Q1 2016 before it gradually finds it footing. Previously the NAB saw the exchange rate bottoming at .7100.
Alongside the downward revision to the AUD/USD, the bank also slashed its AUD/NZD forecasts, predicting the Australian dollar will buy 1.13 New Zealand dollars at the end of Q1 2016, down from 1.18 forecasted previously.