Fx flash aud strength not justified 5 august 2016

FX Flash

Group Economics Macro & Financial Markets Research

05 August 2016

AUD strength not justified  RBA: GDP to recover; inflation to remain low for long

Roy Teo Senior FX Strategist

 AUD strength not justified; RBA likely to cut OCR in November

Tel: +65 6597 8616 roy.teo@sg.abnamro.com

RBA: GDP to recover; inflation to remain low for long In the RBA monetary policy statement released this morning, the RBA’s forecasts for economic growth are little changed from previous assessment in May. Economic growth is forecast to pick up from 2.5-3.5% in 2016 and 2017 to 3-4% in 2018.

Underlying inflation is projected to be around 1.5% this year before edging higher to 1.5-2.5% in the following two years. The AUD trade weighted index (TWI) is assumed to be 63 (slightly lower than current levels of 63.7) and the AUD/USD around 0.76.

Firm iron ore prices supporting AUD USD/tonne

Strong AUD not justified by interest rate differentials Level

135 115

Level

1.0

0.85

0.9

0.80

0.8

0.75

0.7

0.70

0.6

0.65 Jan-15

%

1.75 1.50 1.25

95

1.00

75 55 35 Jan-14

Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Iron ore prices (lhs) AUD/USD (rhs)

Source: Bloomberg

0.75 0.50 Jul-15 AUD/USD (lhs)

Jan-16

Jul-16

2y AU-US yield spread % (rhs)

Source: Bloomberg

AUD strength not justified – RBA likely to cut OCR in November As shown in the graphs above, the current resilience and strength in the Australian dollar (AUD) is not justified by interest rate differentials between Australia and the US. The AUD is currently supported by firmer iron ore prices (which we do not expect to be sustainable due to high iron ore inventory in China) and market pricing a lower risk that the RBA may lower the Official Cash Rate this year. A study done by the RBA in 2014 stated that a 10% depreciation in the AUD trade weighted index (TWI) increases service export volume by 13% and inflation by 0.25-0.5% after about 2 years. We expect a 7.5% appreciation in the AUD TWI since the third quarter of 2015 to have a similar negative impact on exports

Insights.abnamro.nl/en

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FX Flash - AUD strength not justified - 05 August 2016

and inflation. We expect the RBA to follow up with another 25bp rate cut later this year in November to bring the OCR to 1.25%. As this is less than 50% priced in by financial markets, a weaker AUD towards 0.73 is likely.

Find out more about Group Economics at: https://insights.abnamro.nl/en/

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FX Flash - AUD strength not justified - 05 August 2016