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Australian Dollar Burns its Doubters as U.S.-China Truce Set to Lift 'Risk Assets' for Longer

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- AUD advances amid risk rally as markets eye U.S-China detente.

- AUD rally burns short-seller Nordea and is now tipped to continue.

- But the AU, Chinese and global economies are still set to struggle.

- And RBA is seen cutting again, likely undermining AUD before long.

The Australian Dollar continued to burn its doubters on Monday when it advanced against a majority of its major rivals as investors celebrated another perceived detente in the trade war between the U.S. and China, which say can go on supporting the Aussie for a while yet. 

Australia's Dollar bested all of its top rivals last week after Chinese and U.S. officials said they will hold talks this month that are aimed at setting up more substantive  October discussions about how to end that trade war between the world's two largest economies. That's boosted investor risk appetites as well as Aussie, although the antipodean unit failed to get the better of the Pound Monday as the British unit celebrated the latest developments in the Brexit saga.

Commitments to the latest talks didn't come soon enough to prevent another round of U.S. tariffs being imposed on imports from China this month, nor the inevitable retaliation that followed, but they could avert the imposition of more levies set to go into effect on December 15. Those tariffs will weigh on the already-embattled Chinese economy and, by virtue of Australia's connection with it, the Aussie too. But a deal averting them would have the opposite effect.

"We would have liked to stay short AUDUSD structurally while the RBA continues the academical discussion, but the geopolitical postponement relief/reflation sadly wrongfooted the timing of our AUDUSD short," says Martin Enlund, chief FX strategist at Nordea Markets

Above: AUD/USD rate shown at daily intervals.

President Donald Trump imposed a 15% tariff on the remaining $300 bn of Chinese exports to the U.S. that are not yet covered by punitive levies, with around half of those levies having been imposed on September 01 and the remainder now scheduled to go into effect on December 15. The decision came at the same time the U.S. increased the tariff levied on the other $250 bn of Chinese exports to the U.S. from 25% to 30%. 

The late-August decision stoked renewed fears for the health of the Chinese and global economies while pushing the Aussie down from 0.68 to around 0.66 against the U.S. Dollar throughout last mont, although that decline has been more-than reversed in the last week since the talks were first reported. Nordea's Enlund, who recommended that clients sell the Aussie at the beginning of last week, now says the ongoing 'risk rally' may continue for a while yet. 

"Given Australia’s geographical position and its strong trade links with China, it is often traded as a lose proxy to the latter’s economic outlook," says Jane Foley, a strategist at Rabobank. "The drop in the value of the AUD this year is likely to be insufficient to put much of a dent in the debate about the need for further policy stimulus in Australia in the months ahead."

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

Both Rabobank and Nordea are sceptical of how long the current U.S.-China truce will last for and are also pessimistic in their outlooks for the Australian Dollar. They say the trade war, when combined with existing weaknesses in Australia's economy, is likely to force the Reserve Bank of Australia (RBA) to cut its cash rate much further in the months ahead in order to support growth in an increasingly inhospitable environment for the commodity-backed currency. 

The RBA has called repeatedly for the government to spend more on infrastructure and public services so as to boost growth in the quarters ahead and lessen the burden carried by the bank. The RBA has cut its cash rate twice in 2019 already, taking it down to a fresh low of 1% as it seeks to lift inflation back to the target level by stimulating the economy with lower borrowing costs. 

"The RBA seems stuck in the kind of discussion that only Phillips Curve apologists can prioritize in the middle of a slowdown. RBA members continue to discuss the level of NAIRU while they have already inaugurated a cutting cycle based on (among other things) weaker labour markets," Enlund writes, in a weekly missive to Nordea clients. "Let us cut through the fog of academic nonsense then. Dear RBA. You need to cut (a lot) more as the unemployment rate is going up not down."

Above: Nordea graph detailing indicated trajectory of unemployment rate.

The RBA said after its September rate decision that it would like to see an “accumulation of additional evidence” that more stimulus is necessary before cutting its interest rate again, although since then retail sales figures for July have surprised on the downside and construction output numbers missed expectations by a country mile. Markets are now coalescing around the idea of a third 2019 cut in October, although analysts are increasingly contemplating the odds of even further cuts coming after that point.  

Changes in rates are normally only made in response to movements in inflation, which is sensitive to GDP growth, but impact currencies because capital flows tend to seek out the most advantageous or improving returns. Rising rates typically draw investment flows toward a currency whereas falling rates, which represent diminishing returns, tend to drive investors out of and deter them away from a currency. 

"The RBA is likely to be under pressure to ease monetary conditions further. Given that the rates may soon be approaching a floor, the debate about whether QE could be used in Australia is likely to remain alive despite Lowe’s conclusion that “we risk just pushing up assets prices”. We expect AUD/USD to edge towards the 0.65 area on a 12 month view," says Rabobank's Foley.

 

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