The break higher in the Australian dollar is likely to be limited
- While President Trump has not been as threatening to the global economy as some had feared (eg, no trade war with China or Mexico – at least so far), his presidency has been characterised by a high degree of mayhem with so far no passage of tax reform or infrastructure spending. In fact, he has just had another bad week: Congress has failed to reform or repeal Obamacare; it has imposed new sanctions on Russia, which can’t be eased by him; several senators warned him not to fire Attorney General Jeff Session; the Boy Scouts issued an apology for a speech he gave at a Jamboree; the military baulked at implementing his policy banning transgender people in the military; and his staff turnover accelerated. Australia’s attempt at political mayhem – with “foreigners” taking Aussie politicians jobs! – arguably pales into insignificance. We remain of the view that the Republican-controlled Congress won’t impeach Trump in relation to the Mueller inquiry (into Russian links and other things) and that tax reform will still be passed (as it’s something Republicans agree on and they need a win). However, while none of the mayhem around Trump has had much lasting impact on the US share market, as it’s benefitted from a “Goldilocks”-like combination of good growth and profits but low inflation keeping the Fed friendly, it has weighed on broader sentiment towards the US.
- Recently, core inflation in the US has fallen back to 1.4% year on year from 1.8% earlier this year and this may slow the Fed with a September rate hike now looking like it will be delayed to December and possibly early next year.
- Australia’s export prices were surging on the back of 10% plus growth in China, with Chinese fixed asset investment growing around 25% per annum (pa) and industrial production growing at around 15% pa.
- The supply of commodities was constrained by years of underinvestment in new mines and related infrastructure.
- The Australian economy was growing at 5% year on year and underlying inflation was 2.8% and on its way to 5%.
- So the RBA was raising interest rates in response at a time when US interest rates had peaked (in the very early stages of the GFC), such that the interest rate differential between Australia and the US was widening, which is normally positive for the Australian dollar.
- Notwithstanding the yoyo ride in the iron ore price, the upside in commodity prices is limited by slower growth in China (with GDP growth running around 6.5-7%, fixed asset investment growing around 8.5% pa and industrial production growing around 7.5% pa).
- The supply of commodities has surged after record levels of investment in new mines and energy projects.
- The Australian economy is growing at less than 2% year on year. In fact, the rise in the $A is a problem for the economy and is likely contributing to the underperformance of the Australian share market this year (it’s up 1.4% year to date) compared to global shares (which are up 9.2%). With mining investment still falling, consumers under pressure and housing construction looking like it is peaking, we need a contribution to growth from trade-exposed sectors like tourism, higher education, manufacturing and farming but a rising $A will work against that. Any tourist operator who was thinking of expanding must now be fearing another run to parity is on the way, which will destroy the flow of foreign tourists and send locals back to Disneyland for their holidays. So it won’t be good for investment either.
- Inflation is running below the RBA’s 2-3% target, and wages growth – the main driver of costs – is at record lows. And the rise in the $A at a time of already sub-par growth risks keeping inflation below target for longer.
- As a result, the RBA is far from tightening. In fact, in its post- August meeting statement it noted that a rising $A “would be expected to result in a slower pick-up in economic activity and inflation than currently forecast”. In other words, the rising $A is a defacto monetary tightening that will mean a lower profile for the cash rate than would otherwise have been the case. And meanwhile with US economic indicators remaining solid the Fed is likely to continue raising rates and start reversing quantitative easing next month. So a resumption of the falling interest rate differential between Australia and the US is likely. As the next chart shows, periods of a falling official interest rate differential between Australia and the US usually see a falling Australian dollar (see black arrows) – not in a straight line, but over time. By contrast surges in the value of the $A (eg 2007-2008 and 2009-2011 – both circled) are associated with rising rates in Australia relative to the US and there is no sign of that.
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