The Australian Dollar Slumps after Lowe Signals RBA Could be Headed for an Interest Rate Cut

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- AUD slumps after RBA abandons bias to raise its interest rate.

- Warning of rate cut prompts sees traders dump AUD en masse.

- Morgan Stanley says buy Pound-to-Aussie rate as AUD to weaken.

The Australian Dollar was left badly bruised Wednesday after the Reserve Bank of Australia (RBA) dropped its bias to lift interest rates over the coming years, prompting traders to dump the Antipodean currency.

RBA Governor Philip Lowe now says the next move in the bank’s interest rate could be either up or down, overturning earlier guidance that suggested the next move would be up.

He also says there's around a 50% probability the next change in the cash rate could be a cut, describing the risks as “more evenly balanced” since the last meeting in December.

“The governor has shifted the RBA’s forward guidance to a neutral stance,” says Gareth Aird, an economist at Commonwealth Bank of Australia. “We no longer expect a rate hike in 2019. Indeed, a rate hike looks to be off the cards for the foreseeable future.”

Lowe told an audience at the National Press Club in Sydney that if unemployment were to see a “sustained increase” and inflation data continues to disappoint during the quarters ahead, the bank might then cut rates. The shift matters to the Aussie because of what it means for Australian government bond yields and the difference between those and their international counterparts. 

"On Tuesday morning the Australian Dollar powered into the lead. Investors interpreted the Reserve Bank of Australia's policy statement to be moderately hawkish, and dismissed the possibility of a rate cut from the RBA. This morning the RBA governor disabused them of that notion, using a speech to point out that rates can go down as well as up. The Aussie fell," says Lee McDarby, Corporate IP Managing Director at Moneycorp.

At this month's policy meeting the RBA held its interest rate at a record low of 1.5% for more than two years, citing below-target inflation and weak wage pressures that will leave price growth beneath the 2%-to-3% target band.

Lowe's comments have weighed on Australian yields while, at the same time, yields in other parts of the world have risen and created an incentive for investors to sell Aussie Dollars and buy other currencies instead.  Interest rate derivative market pricing now implies there's close to a 70% chance the RBA will cut its interest rate to a fresh record low before February 2020.

"I consider this step to be smaller than the monetary policy reversal on the part of the Fed. The following therefore applies: it is correct and logical that the market reacts with AUD weakness to Lowe’s speech, but there is no reason to put massive pressure on the Australian currency," says Ulrich Leuchtmann, head of currency strategy at Commerzbank.

Above: AUD/USD rate shown at daily intervals.

The AUD/USD rate was quoted 1.25% lower at 0.7151 Wednesday and has now risen just 1.4% for 2019 after unwinding an earlier 2.7% overnight. 

"With the market already pricing a partial cut within a 1y time horizon prior to the Governor Lowe speech, the shift in RBA guidance should not be seen a material game changer for AUD and the negative effect on the currency should be rather one off," says Petr Krpata, a strategist at ING Group. 

The Pound-to-Australian-Dollar rate was 1.25% higher at 1.8111 Wednesday and has risen 0.08% this year.

Above: Pound-to-Australian-Dollar rate shown at daily intervals.

“The RBA sees the downside risks to the Australian economy as coming from the global economy first and the domestic economy second. In the domestic economy, housing is at the top of the list,” says Besa Deda, an economist at St George Bank in Sydney.

The RBA has abandoned its earlier “tightening bias” at a time when Australia’s economy is slowing, the housing market is faltering and amid the trade war between the U.S. and China.

U.S. tariffs have slowed the Chinese economy, stoking fears for the global growth outlook but also for Australia, given the world’s second largest economy buys the bulk of Aussie exports.

Approvals for the construction of new residential homes fell by an eye watering -8.4% in December, after having declined by -9.4% in the previous month, taking the annualised rate to -23%.

"In the coming month, we continue to see higher funding costs leading to negative wealth effects, lower consumption and a weaker AUD," says Hans Redeker, head of FX strategy at Morgan Stanley.

Construction activity is slowing in response to a steep and protracted fall in prices across Australia’s eight major cities.

Years of runaway price growth, higher international funding costs and changes to bank lending regulations have all contributed to the cracks now opening up in Australia's housing market, which are of increasing concern to policymakers.

Fears are that the downturn will create negative wealth effects that hurt the economy by deterring households from spending. That could sap demand and reduce inflation, which would mean another headache for the RBA.

"Tighter liquidity conditions now threaten Australia due to its low balance sheet quality, foreign funding reliance, tighter bank regulation, and housing market excesses," Redeker says. "We prefer AUD shorts against high-yielding EMs like BRL or the undervalued GBP, which may gain from declining Brexit risks."

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