As Australian Dollar Becomes Yet More Expensive, Surely RBA Action Looms?

The Reserve Bank of Australia (RBA) has boosted the Australian dollar having delivered a positive assessment of the economy at the start of December, but will they like the AUD becoming increasingly expensive?

The Aussie has found support on fading expectations for an Australian interest rate cut below 2.0% anytime soon. In their December meeting the RBA delivered an upbeat assessment of the economy ensuring the multi-week period of appreciation for the currency remains intact.

"The RBA left rates unchanged this morning and gave a relatively upbeat message, suggesting other areas of their economy away from resources are doing the heavy lifting in their economy. We have held an AUD outperformance bias for a number of weeks now and this only bolsters that view," say Lloyds Bank Research in a briefing to clients in the wake of the decision.

The majority of 27 analysts surveyed by Bloomberg had expected no change to the current 2% interest rate being announced - the surprise was therefore in just how bullish on 2016 the RBA is.

Problems Ahead - Is the AUD too Expensive?

The meeting came in an environment of Aussie dollar strength within which we have seen the pound to Australian dollar (GBPAUD) shift lower in a downtrend that has been in place since September.

The Australian to US dollar exchange rate has meanwhile strengthened from the September lows around 0.69 to trade back above 0.70 in November – this despite currency markets pricing in a US Federal Reserve interest rate rise in December.

The Australian dollar is therefore trading with a positive bias – something the RBA will not be pleased to observe as the Bank wants a weaker exchange rate to continue delivering the heavy lifting required to boost the non-mining sector of the economy.

Despite an ever-strengthening trend markets should be wary of becoming overly optimistic on further Australian dollar strength from current levels say analysts at BMO Capital.

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“The reason that AUD has rallied is that markets priced out one RBA cut after having two cuts priced in. Whether he cuts this time or not, we think Stevens will do his best with his Statement to put two cuts back in to the currency,” says Greg Anderson, Global Head of FX Strategy at BMO.

BMO were however caught wrong-footed ahead of the December meeting recommending entering the meeting short AUDUSD, "we also like entering the meeting with a long GBPAUD position," said Anderson.

While the call has proved to be a wrong one we cannot discount the message from BMO which remains entirely relevant - the Australian dollar is strengthening and the higher it goes so do the risks that the RBA will act against it.

If an attack on the exchange rate is not made in the January meeting then the liklihood of that attack increases for the February meeting.

It has been seven months since the RBA cut its base rate to 2.00% and after seven straight holds and a strong employment report for October, most market participants expect the RBA to continue holding a steady rate.

In his 03-Nov Statement, RBA Governor Stevens noted the following:  “Australia’s terms of trade are falling…the Australian dollar is adjusting to the significant declines in key commodity prices.”

According to Anderson the latter portion of that comment no longer appears accurate. The CRB and JOCI commodity price indexes are down about 6% since 03-Nov, but AUDUSD is up 0.2%.

“Moreover, because of the weakness in the currencies of Australia’s key trading partners, the trade-weighted Australian dollar is actually up about 3% over that span,” says Anderson.

While the December meeting could be uneventful what Anderson and his team at BMO hint at is that the RBA will likely become more irritable with the current levels in the exchange rate.

We have seen in the past how the RBA is able to jawbone the AUD lower and this may well be the case over coming months.

Therefore we would expect further Australian dollar strength to remain limited with  risks to the downside increasing from early 2016.