The Australian dollar has been walloped by the British pound in mid-week trade after some eyebrow-raising Australian inflation data was released.
After what has been a stand-out performance by the Aussie dollar so far in 2016 we have been reporting of late that it could be time for the currency to start turning lower.
We didn't realise the turnabout would be so violent though; after an impressive run that took in fresh 2016 highs noted just north of 0.78.against the US dollar the pair has turned sharply lower and is at 0.7617.
In mid-week trade the pound to Australian dollar has shot higher by 1.78% to reach 1.9158, taking those with outstanding Aussie payments to the best exchange rates since early March.
The culprit for the rapid turn in fortunes for the antipodean currency is the release of quarterly inflation data that read at -0.2%, well below the previous 0.4% reading and below the level forecast by economists at 0.3%.
The fall in prices has been helped by the impact of lower oil prices on the cost of petrol, which dropped 10% compared with the previous quarter and is now selling for under $1 a litre at some garages.
In addition, domestic inflationary pressures appear to be subdued and lacklustre wage growth is unlikely to result in a change to the domestic inflation landscape.
This all means the Reserve Bank of Australia (RBA) will likely keep interest rates at present levels for longer, in fact the bar to cutting rates has now been lowered.
"The RBA stance is clear – while they have room to cut interest rates, they are reluctant to do so. It’s jobs and growth, not inflation, that counts most for the RBA board. However, in my view the market is looking for an excuse to sell AUD, and the CPI numbers fit the bill," says Michael McCarthy at CMC Markets.
Australian Dollar Overdue a Decline
Going into the inflation data release we noted the Australian dollar’s period of strengthening had reached overextended levels and suggested that, on balance, risks of a deeper decline on the back of any negative news are growing.
“The run is starting to look a little stretched and there is risk for a pullback and potential bearish resumption. Still, a break back below 0.7477 would be required to strengthen this outlook and take the immediate pressure off the topside. Until then, a test of next key medium-term resistance in the 0.7850-0.8000 area should not be ruled out,” say LMAX Exchange in a briefing to clients.
So we are increasingly open to the prospect of the short-term pullback turning into something more long-lived.
RBA Could Look to Slash Australia’s ‘Carry’ Advantage
Whether or not the currency succumbs to meaningful weakness ultimately lies with the Reserve Bank of Australia.
The Australian dollar entered 2016 with analysts expecting a soft performance, however, the rapid acceleration in commodity prices, and the 'return to yield', proved forecasters to be wrong-footed.
The Australian dollar, like the New Zealand and Canadian dollars, have risen in 2016 as global investors seek out the impressive yield offered by the high interest rates in these countries, which are ultimately determined by central bank policy.
For instance, New Zealand’s base rate is set at 2.25% while that of Australia is set at 2.0%.
Consider that the base rate in the UK is set at 0.5%; it is possible to borrow in cheap sterling and park it in either New Zealand or Australia and earn decent interest. This dynamic is known as the carry trade, and it is once again having a notable impact on global currency markets.
Positioning analysis from investment bank BNP Paribas suggests the pro-carry environment has led to a cut in the NZD’s recent extreme short positioning to -3 and an increase in long AUD positioning to +21.
CAD positioning is slightly long at +7.
In short, foreign exchange markets are witnessing increased confidence in the AUD, NZD and CAD, thanks largely to the demand for these currencies from carry dynamics.
Interest rate policy decisions at the Reserve Bank of Australia will therefore be instrumental going forward in determining whether the AUD can hold onto its interest-rate-inspired advantage.
There are suggestions that the RBA is growing increasingly uneasy over the rich valuation of the Australian currency - a stronger currency eats away at the country’s competitiveness in terms of global trade and there must come a point when the currency’s strength becomes an all-out negative.
Nevertheless, the RBA is expected to maintain an easing bias when it meets next week, though the central bank should stop short of signalling any need to ease further unless Wednesday’s inflation comes in well below expectation.
We also watch for any direct mention of the Australian dollar’s current valuations as this could suggest the RBA may cut rates in the future simply to target a lower AUD.
Odds for a May rate cut at the RBA sit at a very low 15%, while only 17bps of easing priced in for the December meeting.
There is however scope for the RBA to turn more dovish argue BNP Paribas who are forecasting the Australian to US dollar exchange rate to fall to 0.76 in a month’s time and down to 0.73 in three months.
Analysts also base a bearish AUD stance on extended market positioning and currency valuations.
Furthermore, China’s shift away from manufacturing towards the service sector and the continuation of two-speed growth in China will not be supportive for Australian export prices.
Beware a British Pound Recovery
What of the pound to Australian dollar exchange rate? The pound sterling has, like the euro and dollar, also suffered at the hands of the AUD’s resurgence.
However, the GBP’s declines have been more dramatic courtesy of the EU referendum due for mid-year which continues to undermine confidence in the UK unit and it remains hard to get excited about GBP until the referendum passes.
That said, the economic fundamentals in the UK remain firm and this should yield a positive outlook for the pound, particularly once the referendum has passed.
“The outlook for the GBP is positive and, with short GBP positioning at an extreme, we think risks are skewed to the upside. We expect the BoE to start its tightening cycle in February 2017. The UK’s balance of payments position is solid, with the current account deficit financed by FDI and portfolio investment inflows,” argue BNP Paribas.
The pound sterling is forecast to rise to 1.51 against the US dollar in three months, suggesting something of a post-EU vote boost and a return to fair value.
This could well feed into the GBP/AUD in a positive manner.
Looking at the charts we would suggest it is too early to call any kind of turnaround in the GBP/AUD’s fortunes however we note that some short-term positives are building.
We note that GBP has broken above the 20 day moving average and is about to break above the 50 day moving average.
Such moves would signal the potential shift in momentum, the first requirement to a turnabout in fortunes in the exchange rate that could well see the pound sterling dominate the remainder of 2016.