Australian dollar: a bull market with caveats

BY DEB SHAW | 

  • Global conditions remain ideal for AUD, yet performance has been disappointing
  • Weak household balance sheets and neutral monetary policies weigh on the currency
  • Current bull market set to continue, but likely to be fairly weak

For a currency that strengthens when global growth accelerates, recent moves in the Australian dollar have been fairly disappointing. While the currency rocketed higher between mid-December and late January, the Australian dollar has sold off sharply in recent weeks. The currency first began weakening against the Japanese yen, which led us to downgrade our short-term AUD/JPY outlook to neutral on January 29. While the pair traded above 88.0 at the time, AUD/JPY is trading below 86 today. Turning to the US dollar, we downgraded our short-term outlook on AUD/USD to neutral earlier today, and expect to downgrade the currency itself later this week. The Australian dollar rally is rapidly running out of momentum. Looking at recent developments, we believe the currency is set to underperform thanks to weak economic growth and neutral monetary policy expectations.

 

Australia not keeping up with developed market peers

Looking at Australian economic data, the current upturn has been decidedly weaker than previous booms. Historically, Australia has comfortably outperformed other developed markets with year-over-year GDP growth rates in excess of 3%. For the first three quarters of 2017 (Q4 2017 data has yet to be announced), Australian GDP growth has averaged just 2.1%. This figure is right in line with traditional slow-growth regions including the Eurozone (2.4%) and Japan (2%). Despite a strong turnaround in industrial commodity prices and the fortunes of the Chinese economy (the country’s largest trading partner), Australia has been underperforming. An overview of year-over-year GDP growth rates are shown below:

Recent “boom” looks weak at best

2-6-2018 AU GDO
Source: Australian Bureau for Statistics

 

As can be seen above, Australian growth rates have been steadily declining since 2014. While year-over-year growth in the most recent quarter was 2.8%, this was primarily due to negative growth in the same quarter of the previous year (i.e. base effects). As such, Q3 2017 data has been omitted from the graph above.

Looking more deeply at the Australian economy, exports remain strong thanks to accelerating commodity prices and significant demand from China. Last year, China became the world’s largest crude oil importer, surpassing the United States. Chinese demand for Australian commodities (such as iron ore and copper) also continues to strengthen. The external environment has been fairly supportive for the country. Instead, the biggest drag on growth has been domestic conditions. Retail sales, an indicator of consumer health, have been sluggish. Throughout 2017, Australian retail sales have missed estimates and have slowed relative to historical growth rates in 2014 and 2015. This is shown below:

Not much oomph

2-6-2018 AU retail sales
Source: Australian Bureau for Statistics

 

Beyond weak domestic conditions, Australia is also fairly vulnerable thanks to its significant housing boom and associated consumer debt. Australian consumers carry some of the world’s highest debt loads (even beating countries with negative interest rates such as Denmark and Sweden). This is partly explained by the country’s close economic ties with China (Australia is a significant destination for Chinese real estate investors), and also because of “negative gearing”. Unlike other countries, losses from income-producing real estate (primarily due to mortgage interest costs) are income tax deductible in Australia. This provides an outsized incentive for households to invest in properties as an investment and has contributed to the nation’s apartment building boom. An overview of household debt to GDP is shown below:

Don’t look below

2-6-2018 AU household debt
Source: CEIC

 

As a point of reference, US household debt to GDP, prior to the 2007-2008 financial crisis, peaked at 95.5%. Australian household debt to GDP was 138% at the end of 2016.

 

Reserve Bank of Australia in no hurry to raise rates

Given relatively weak domestic growth and surging household debt, the Reserve Bank of Australia (RBA) is in no hurry to join its developed market peers in tightening monetary conditions. While hopes for rate hikes surged after Canada raised rates last summer (similar to Australia, Canada is heavily reliant on commodity exports and also suffers from high consumer debt), the RBA has stubbornly maintained its neutral stance.

Following its decision to hold interest rates at 1.5% earlier today, the RBA has signaled slightly more confidence in its outlook. While maintaining its view that household consumption was a “source of uncertainty”, the Bank pointed out that a “further gradual reduction in the unemployment rate” is to be expected this year. Looking at inflation, the RBA predicts “CPI inflation to be a bit above 2 percent in 2018”. While the RBA’s statements are moving in the right direction, a rate hike in the near-term still looks unlikely.

Compared to its developed market peers, this makes the Australian dollar relatively unattractive. Expectations for US rate hikes are accelerating this year thanks to strong US jobs and inflation figures. Looking at the European Central Bank, the consensus expects the ECB to end its asset buying program entirely in the latter half of this year thanks to strong growth data. Meanwhile, the Bank of Japan is expected to weaken the pace of its monetary easing efforts. As other countries catch up to Australia, the RBA’s policies work against the Australian dollar.

 

AUD bull market to remain weak all things considered

Thanks to strong global growth, particularly in the Eurozone and Japan, it’s too early to suggest that a downturn lies in store for the Australian dollar. As we wrote yesterday, we expect the US dollar bear market to continue, which is typically bullish for commodity currencies such as AUD. Despite our optimistic outlook on the currency, the Australian dollar bull market is likely to be weak thanks to mediocre growth and limited help from the Reserve Bank of Australia.

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