Australian dollar sticks to 75 cents – what’s next?

The Australian dollar has been on a downtrend versus the US dollar since 2011, although to be fair, most currencies have been losing ground against the greenback in the last 2 years as well. It has been tempting for some to call a bottom around the 68-71 cents level, as a sharp reversal rally to 78 cents was triggered when those levels were tested. The May rate cut however, together with speculation that an additional cut could take place soon, has dampened bullish sentiment in the aussie and has capped the pair since.

The Australian dollar is caught in many cross-currents recently. On a longer time frame, the resource sector cool-down has been managed relatively well, as the GDP growth rate has been fluctuating between 2 and 3%. The unemployment rate has also dropped below 6% this year and was around 5.7-5.8% this year (with the exception of January).

In the latest data release, headline inflation was at 1% during the second quarter, while other measures favored by the RBA which are meant to capture the longer-term trends of inflation, showed higher readings. The Weighted and Trimmed Mean CPI year-on-year change was at 1.3% and 1.7% respectively. The RBA’s goal is to have inflation between 2% and 3%, which means that inflation is undershooting.

The recent elections have meant that the Conservative Party will retain power, but there are still some political risks and related uncertainty as the victory was a very narrow one. There has been some movement away from the two main parties of Conservative and Labor, which could complicate the political landscape.

Back to the economy, the real estate market in certain residential areas in Australia looks quite hot and there is a need for it to cool down. Cutting interest rates would probably fan even more real estate speculation, which would be an unwelcome side-effect of lower interest rates.
It is also interesting that the Reserve Bank of Australia does not shy away from commenting on the exchange rate; a practice that a lot of other developed country central banks try to avoid. 75 cents and below could be levels that the RBA feels happy about, but any attempts to drive the currency higher to around 80 cents say, might be resisted by the bank. Therefore the RBA would like to avoid a strengthening in the exchange rate and given justification on the inflation front, it could move on rates if the exchange rate strengthens.

Therefore, despite the relatively good shape of the Australian economy and the substantial upside it has when commodities eventually bottom out, in the medium-term it probably makes more sense to be short the Australian dollar. Should the currency strengthen from this level, the RBA will probably not hesitate to take additional action in the form of rate cuts – following some jawboning and verbal intervention of course. It is also clear that regardless of the movement of the exchange rate, the bias for the Reserve Bank of Australia is to cut rates further – either as soon as next week’s meeting (August 2) or in any case before the end of the year. The RBA cut rates twice from 2.5% to 2% during 2015 and has so far cut once this year as it has brought the target cash rate down to 1.75%. One additional cut for this year appears quite likely in the current state of economic affairs; only the timing itself could be a little uncertain.

To sum up, one should “not fight the RBA” at this stage and probably be positioned for additional aussie weakness. A retest of the 68-70 cents range is likely, despite the fact that US dollar bulls are not as inspired these days as the US rate hike campaign is proving much slower than some hoped for.