Australia clocked the fastest growth in the developed world outside Europe last year, commodity prices are rallying and the government is in no hurry to return the budget to surplus. So why are traders still pricing in an interest rate cut in the coming 12 months?  One reason is the Federal Reserve. With Chair Janet Yellen triggering declines in the US currency in recent weeks, her Australian counterpart Glenn Stevens has to contend with an appreciating local dollar that clouds the growth outlook down under. As a result, while markets and economists expect no change at the Reserve Bank of Australia’s policy meeting today, traders are pricing in another easing in the next year.
“The stronger currency has fed straight in to the interest-rate debate,” said Michael Blythe, chief economist at Commonwealth Bank of Australia, the nation’s biggest lender.
“Whether they act will depend on how the central bank views the Australian dollar’s trajectory and how that will feed back into the inflation and growth outlook.” Blythe predicts the Aussie has further to climb from its current level near 76 US cents, up from an almost seven-year low of around 68 cents in January.
Stevens said in February testimony that whether to stand pat “or go down some more” remains the central bank’s key issue, and in March reaffirmed that low inflation provided scope to cut rates. Still, policymakers are reluctant to move lower given the economy accelerated in 2015, unemployment has dipped to 5.8% and the government has signalled that balancing the books will take time.
“It is a long-term project,” Prime Minister Malcolm Turnbull said of restoring the budget position, in an interview with Sky News on Sunday. “The critical thing that we have to do is to ensure we maintain strong economic growth.” An 11% turnaround in the currency over the last 2 1/2 months is jeopardising the economy’s transition as Australia pursues growth in non-mining industries. Commonwealth Bank this week cited central bank research that shows a 10% appreciation will reduce growth by 0.5-1 percentage point over two years; and cut the year-end inflation rate by 0.25-0.5 percentage point over each of the following two years. Stevens last month noted there had been some return of “risk appetite,” the US dollar had fallen and commodity prices had also risen, in response to questions on the renewed strength in the currency following a speech. Iron ore, Australia’s biggest export earner, rebounded 23% in the first quarter despite scant evidence of demand growth.
“Unless you think that the commodity price trend now is different and we’re heading back to a world of considerably higher prices for an extended period, and the Fed’s never going to lift rates, it’s not clear that that situation will warrant a much higher exchange rate than this,” the governor said on March 22. “There’s some risk actually that the currency might be getting a bit ahead of itself.” Westpac Banking Corp chief economist Bill Evans said the central bank’s use of strong language on the currency’s strength from March 2014 – when it first referred to the Aussie as being high by historical standards – through to August 2015 when it adopted the current “is adjusting” commentary proved successful.
Yet he said the language is likely to stay unchanged in today’s statement from Hobart, in one of the RBA’s occasional meetings outside Sydney.
“Central banks are inherently conservative institutions,” Evans said. “We expect that, like ourselves, the RBA will be sceptical about the recent ‘recovery’ in commodity prices and, more importantly, like ourselves, still expects the Federal Reserve to raise rates in June.”
Outside the Aussie’s appreciation, local data have been mixed since last month’s meeting: Gross domestic product grew 3% in the final three months of 2015 from a year earlier, exceeding expectations, while business confidence and conditions edged higher. Meanwhile, consumer sentiment slid and employment was little changed.
Australia’s economy has been supported by consumption as the wealth effect from higher housing prices emboldens shoppers, reducing the nation’s savings ratio. The flip side of that is household debt has surged to 186% of disposable income, a record high.
Data released yesterday showed Australian retail sales stagnated in February, the second month in three they’ve come in flat. The Aussie dropped 0.4% to 76.42 US cents at 12:53 pm in Sydney from 76.70 just before the report was released. More positively, manufacturing, which took a beating during the country’s mining investment boom, powered ahead last month with an industry gauge reaching the highest level since 2004.
“The strong manufacturing performance and its expansionary run since the middle of 2015 are in large part due to the boost provided by the lower Australian dollar,” said Innes Willox, chief executive officer of Australian Industry Group. “That said, the sharp lift in the value of the Australian dollar over the past two and a half months will test some manufacturers and, if maintained, can be expected to slow the pace of recovery.”