Market Insights: $A could be heading for new test of US70c | BetaShares

Market Insights: $A could be heading for new test of US70c

BY David Bassanese | 26 July 2016
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The Australian dollar have proven stubbornly resilient in recent months, raising doubts about my year-end call that it would fall to US65c. That said, a number of forces appear to be now conspiring to push the little Aussie battler lower in the months ahead.

$A Stubbornly Range Bound over the Past Year

As seen in the chart below, after consistent declines since the peak in commodity prices in 2011, the Australian dollar began to flatten out in mid-2015. It has since traded in a relatively wide sideways range, twice attempting to break below US70c (in September 2015 and January 2016) and touching a recent high around US78c in April.
$A
But while the recent breakout to US78c might suggest resumption of an upward trend, there are three key forces which could push the $A lower in the months ahead.

1.  Fed gets more aggressive

One of the factors that supported the $A (and commodity prices in general) earlier this year was a lurch back to dovishness by the United States Federal Reserve after its first interest rate increase in nine years last December.  In turn, the Fed’s hesitation reflected a bout of global financial market instability (and undue strength in the $US) following its December rate rise, together with a slowdown in US economic growth during the March quarter.  The recent Brexit decision effectively extended the Fed’s period of hesitancy.

But with global markets rebounding from the Brexit decision and the US economy again picking up speed, the case for another US interest rate increase is building.  Indeed, this Friday’s Q2 US GDP result is likely to show that annualised economic growth accelerated to around 2.5%, from 1.1% in the March quarter.  US employment growth also surged back in June after a rogue one-off weak result in May.

While the Fed is not expected to raise interest rates at this week’s policy meeting, there’s a strong risk its post-meeting Statement will allude to the possible desire to raise interest rates within the next few months.  Given it may be difficult for the Fed to raise rates in November (one week ahead of the Presidential election), it will either need to raise interest rates in September, or accept an extended wait until December. Wall Street is only partly prepared for a more aggressive Fed, with Fed funds futures implying a 25% probability of a September rate hike, and a move by December still rated only a 50-50 chance.

2. RBA likely to cut Interest Rates further

This week’s Australian June Quarter consumer price index report is likely to show annual underlying inflation is stuck at around 1.5%p.a., if not a bit lower.  Low inflation reflects continued very weak wage growth, intense retail sector competition and subdued import prices due to a still firm $A.

As a result, confirmation of sustained below-target inflation is likely, in my view, to encourage the RBA into cutting official interest rates again next week – thereby achieving my long-held target of a 1.5% cash rate.

At this stage, the market is still pricing only a 60% chance of a rate cut next week, though that should move closer to 100% should the CPI prove as weak as expected.  What’s more, if the RBA cuts interest rates, chances are that the market will instinctively price in deeper interest rate cuts either later this year or early next year.

3. Iron ore price likely to sink again

Spot Iron ore prices have had a wild ride over the past year, but the fundamentals still point toward lower rather than higher prices in the months ahead.  For starters, with Chinese economic growth appearing to stabilise in the June quarter, the case for more near-term policy stimulus – which tends to be positively greeted by commodity speculators – has waned.

ironore.JPG

What’s more, the recent production reports from the major iron ore producers of the world still point to rising supply in 2017, despite some weather related production set-backs earlier this year.  Last, but not least, rising supply yet subdued Chinese demand has seen iron ore stockpiles in Chinese ports again rise to near-record levels. Despite the high level of speculative activity that now  seems to drive Chinese iron ore price futures over the short-term, fundamentals still suggest a corrective drop in prices to well below US$50/tonne in coming months.

All up, several forces may well conspire to push the $A lower in the months ahead.  And even if the $A remains stubbornly high, however, the scope for upside from current levels still seems relatively limited, with downside risks much greater.

Investors that share my view that buying the $US against the $A around current levels seems a good risk-return investment, may consider the BetaShares US Dollar ETF ASX code: USD.

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