Aussie dollar maintains strength despite consecutive rate cuts by RBA

By:
Garima Chitkara
Published on:

The recent strength of the Australian dollar has continued unabated since April, despite dovish statements from the Reserve Bank of Australia (RBA) and a second cut in a row on May 5, bringing the cash rate down to a record 2%.

The Australian dollar, which loosely tracks the price of iron ore, has remained strong – hovering in the A$0.79 to A$0.80 range to the US dollar – during the past six weeks.

Kay_Van-Petersen-160x186
  They know there’s a problem. But knowing when it actually comes home to roost is something else entirely

Kay Van-Petersen,
Saxo Capital Markets

Market participants such as Sean Callow, senior currency strategist at Westpac, have attributed the Aussie dollar’s stubborn relative strength to the recent increase in the price of the commodity after a rout at the start of the year, which saw its price plummet from $80 in October to $47 in mid-April. It has since rallied 12% to close to $60.

Iron ore formed approximately 23% of Australian exports at the end of 2014.

"After months of gloom over iron-ore prices, some of the market’s more apocalyptic forecasts have been put on the backburner for now," says Callow. "They might return, but for now they are not very plausible."

Kay Van-Petersen, Asia macro strategist at Saxo Capital Markets, expects this to change by the end of the year, predicting a fall in AUD to as much as A$0.70 to the US dollar, if the Federal Reserve hikes rates in the second half of the year, as he is expecting.

This is much lower than the A$0.75 to the US dollar level that RBA governor Glenn Stevens put forth as the figure the central bank is working towards.

"It’s a bit spurious to have a level because there is a combination of different things impacting what the right level in the currency should be at a point in time," says Van-Petersen.

"It’s not just about the weakening of AUD, but also where the commodity prices are going. So, for example, if the AUD is at 0.75 and commodity prices fall 30%, this level becomes too expensive and so on."

The recent weakness in the US dollar hasn’t helped. Inflows into Australian debt markets, which began in the aftermath of the global financial crisis in search of yields, have continued and contributed to AUD strength as well.

However, the sustainability of these flows might be unlikely if the Fed hikes rates this year.

Tracking iron ore and AUD/USD in commodity bull phase
AUD_iron_ore_bull
l = iron ore; r = AUD/USD

Tracking iron ore and AUD/USD in past month
AUD_iron_ore_May
l = iron ore; r = AUD/USD
According to Van-Petersen, at 2% the spread between Aussie government debt and US 10-year treasuries has compressed and any further hike could see US treasuries go up as much as 3%.

Westpac’s Callow seconds this, adding that foreign flows, especially from Japanese investors, have disappointed over the past two months. He believes this might be due to the strength of the AUD against the yen, which has, during the past two weeks, flirted twice at the ¥96-to-the-Australian dollar level.

"We think the AUD has become a bit too expensive for Japanese investors," he says. "They will come back, but maybe not at these prices."

Saul Eslake, Australia economist for Bank of America Merrill Lynch (BAML), provides another explanation which might be the most likely culprit for Aussie dollar strength. He points to six liquefied natural gas plants that are in construction at various parts of the country at a combined cost of A$200 billion.

The plants are majority foreign-owned and, according to Eslake, attract inflows of between A$45 billion and A$50 billion every year.

"So a lot of foreign money is coming in, which is all unhedged because direct investment cannot be hedged and is holding the Australian dollar at a higher level than what it would otherwise be," he says.

"For as long as these flows continue, the currency won’t fall as much as fundamental macroeconomic models might project. But once these flows cease, as these projects finish, then the currency can fall a lot."

There is a perception there is a currency war on and any central bank that’s not cutting rates will see its currency rise
Saul Eslake, BAML

Eslake says that given the uncertainty around large projects, it is hard to estimate when construction will end. One plant has finished construction as of this year, another is expected to complete by the third quarter of 2015. The remaining four will begin construction between the end of this year and 2016.

The RBA, in its monetary policy statement and its quarterly statement released on Friday, expressed its concerns on the currency level.

Eslake says the central bank’s belief that a rate cut will reduce its strength has proven misplaced as the AUD continues to trade close to A$0.80 to the US dollar and remains above its February level of A$0.77 to the US dollar when the RBA first cut rates.

"There is a market perception that there is a currency war on and any central bank that’s not cutting rates will see its currency rise," he says. "There was a lot of market pressure on the RBA to cut rates."

Mining slowdown

Saxo’s Van-Petersen believes a rate cut was necessary, given the state of the Australia economy, whose dependence on mining-based exports will prove detrimental further down the line as demand for its iron ore from China, its largest trading partner, continues to dip.

"The Australian economy has to make a structural pivot back to other areas of the economy where non-mining investment and activity is actually driving growth," he says.

"For the RBA and the government, it’s going to be about how quickly they can ramp up the other drivers of GDP growth before the mining slowdown becomes truly problematic."

Van-Petersen concludes: "They know there’s a problem. But knowing when it actually comes home to roost is something else entirely."