June 2017 Australian Dollar Outlook

The Australian dollar will continue to be influenced strongly by trends in the global economy with the resources sector and commodity prices continuing to have a major impact on the overall outlook.

Developments in the US and Chinese economies will have a very important influence with Federal Reserve policies having a big impact on overall financial risks and risk appetite.

Political developments in the US will also be very important with the Trump Administration’s economic policies have a big influence on domestic Federal Reserve policies and the international trade outlook. The Administration’s policies will feed through into the Asian economies and the Australian outlook.

Domestic concerns increase

The recent Australian data releases have been generally weaker than expected and will cause some alarm over the outlook. The Australian economy has not endured a technical recession for 25 years, but the latest data will increase market nerves.

This month, Australia reported a 4.0% decline in capital expenditure for the third quarter after a 5.2% decline for the second quarter. Construction work also contracted for the third quarter.

There were also much weaker than expected monthly readings for home sales and building approvals reported at the end of November which downgraded growth expectations.

The poor run of data culminated in a GDP contraction of 0.5% for the third quarter compared with expectations of a slight increase. This was the first contraction in five years and the sharpest decline since 2008. Annual GDP growth slowed to 1.8% in the latest quarter, below the long-term average.

Low interest rates should support demand and there will be a recovery in government spending, but overall growth is liable to be subdued.

Reserve Bank on hold

After cutting rates at the August policy meeting, the Reserve Bank of Australia (RBA) has held interest rates at the record low of 1.50%.

Inflation data remains generally weak, but there was a 0.7% increase in consumer prices for the third quarter with underlying prices rising 0.4%. Headline inflation in annual terms edged higher to 1.3% while the underlying rate was 1.5%, but this was still below the 2-3% RBA target level over the medium term.

The RBA, under recently appointed Governor Lowe, will remain concerned over low inflation, but there will be expectations of a gradual improvement in inflation over the next year and the central bank is likely to be patient. Overall, the RBA is likely to be very reluctant to cut interest rates further, especially with concerns over the housing sector around Sydney, although the pace of tightening is liable to be slow next year.

In this context, there will be a possible narrowing of yield spreads over the US dollar if the Fed tightens at a faster pace.

Commodity prices rebound

Trends in commodity prices will inevitably have an important impact on the Australian dollar given the importance on trade and the wider economy.

The latest RBA commodity price index recorded an increase in SDR terms of 32.1% in the year to October with gains fuelled by sharp gains in iron ore and coal prices. The Australian dollar will remain very sensitive to changes in commodity prices with the currency advancing strongly if there is a further sustained increase in prices.

In contrast, a slide in prices would undermine the Australian dollar and global growth trends will be very important. Very accommodative monetary policies seen over the past year should provide near-term support to the global economy, although there is an important risk that conditions will deteriorate from the second quarter of 2017 given structural weaknesses.

China remains crucial

Trends in the Chinese economy will continue to have an important impact on the Australian outlook, especially given the importance of commodity earnings. The recent PMI data from Chinese has been generally encouraging with the manufacturing data at the strongest level since 2014 and an improvement in the services sector.

There are still major concerns surrounding the property sector as the central bank battles to retain control. Efforts to curb excessive leverage and borrowing have continued, but the central bank remains extremely concerned surrounding the risks of a hard landing within the economy and is unable to tighten aggressively for fear of putting sharp downward pressure on prices.

A sharp deterioration in the property sector would also risk a further increase in capital outflows which would destabilise the economy and undermine the yuan.

US Federal Reserve 

US Federal Reserve policies will continue to have an important impact on the Australian currency. The Federal Reserve Open Market Committee (FOMC) has delayed raising rates during 2016 with the planned June increase thwarted by a weak employment report and UK referendum no vote. With hindsight, the Fed would probably have been best served by pushing ahead with the June hike.

The FOMC will, however, increase rates at the December meeting which will take the Fed Funds rate to a 0.50-0.75% range.

There will be overall confidence in the domestic economic outlook and the Fed will be expecting to increase interest rates further in 2017 to continue the process of policy normalisation. At this stage, however, the US central bank is still expecting rates to be increased at only a very slow rate. A gradual policy tightening would make it harder for the Australian dollar to make headway.

A tightening of financial conditions would tend to erode the potential for capital flows into carry trades which would tend to undermine the Australian currency.

The Trump effect

Even at this stage, there is a small possibility that Trump will not formally be sworn-in as President given that the Electoral College could block his nomination

Assuming he is sworn in as President, his Administration and Republican dominated Congress will have a potentially very important impact and the net risks will tend to be negative for the Australian dollar.

Trade policies will be a very important focus for the new Administration with Trump committed to pulling the US out of the Trans-Pacific Partnership (TPP). Increased trade tensions would tend to put downward pressure on global trade volumes. US trade measures would also increase the risk of retaliatory actions which would have a serious impact in undermining trade and also have a very negative impact on the Australian currency.

If the Trump Administration does push for an aggressive fiscal expansion, there would be the risk of a faster pace of increase in US interest rates.

Risk factors

• Yellen could resign as Federal Reserve chair which would trigger major tensions within the Fed and potentially lead to a more hawkish stance.
• A serious escalation in geo-political between the US and China would undermine risk appetite and hurt the Australian dollar.
• There is an important risk that Australia will lose its AAA credit rating due to persistent concerns surrounding fiscal policy and an inability to curb government debt. A downgrade would undermine overall confidence and weaken investment inflows.

Summary

The principal feature is liable to be uncertainty with major unknowns surrounding US economic and political direction next year.

The immediate outlook for the global economy looks favourable with previous very loose monetary policies continuing to provide strong support and there is also scope for a more supportive global fiscal policy, both factors which should support the Australian dollar.

The election of Trump as US President has created enormous uncertainty and will inevitably have an important impact on the Australian dollar. A boost to US and global growth would on balance be supportive, but trade tensions would pose an important threat.

The Chinese outlook will also be an extremely important risk factor with the on-going risk of a hard landing as the property sector collapses under the weight of bad debts.

The RBA is likely to be very cautious in tightening monetary policy unless there is a sharp increase in global inflationary pressures.

Overall, the Australian dollar can maintain a firm short-term tone, but will struggle to make much headway with risks gradually increasing during 2017 with limited losses the most likely outcome.