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What the Cockroach Principle Tells us About the Australian Dollar's Outlook

RBA and the cocroach principle to hurt Aussie dollar further

Having secured the title of the worst performing currency in G10 over the course of the first week of May we hear that further declines in the Australian dollar’s value are likely.

  • 50% chance of another RBA interest rate cut, this poses risks to AUD on a range of cross rates
  • The GBP/AUD manages to crack through the 100 day moving average, invites test of 2.0
  • “The US dollar looks soft enough near term to reinforce demand for AUD/USD on dips” - Westpac’s Sean Callow.

Recent weakness in AUD comes almost exclusively from the Reserve Bank of Australia where a surprise interest rate cut at the start of May triffered AUD weakness that was reinforced by a downgrade to inflation expectations at the end of the week.

Australia’s currency has long found support from foreign inflows of capital as investors seek out the country’s superior interest rate yield, courtesy of the central bank’s high base interest rate.

The cut to 1.75% from 2% in the base interest rate dramatically diminishes that advantage and prospective currency inflows fall.

And, the rate could be slashed further researchers tell us; something that will likely further hamper the currency's attractiveness.

“It is hard to imagine that a single RBA rate cut this year will suffice to address the unexpected step lower in Australian inflation. This is in line with the familiar “cockroach principle” of interest rate changes: there’s never just one,” says Sean Callow at Westpac Global Markets in Sydney.

Westpac believe Governor Stevens will leave his successor Phil Lowe in Sep with a 1.5% cash rate, lowering the profile for AUD/USD in coming months. "Such a prospect is currently priced about a 50% chance. This poses risks to AUD on a range of cross rates, if markets start to move towards our view in the weeks ahead," says Callow.

Westpac reckon the impact of the RBA’s rate cut is likely to be long-lasting, including largely removing the prospect of AUD/USD making a push towards 0.80, even with the US dollar’s outlook being lukewarm.

Other economists agree that the assessment that policy makers are done with slashing the interest rate.

"This is unlikely to be a 'one and done' cut. The RBA nearly always follows up with another cut. And we expect this time to be no different," says Felicity Emmett at ANZ Research.

Emmett believes the RBA’s decision to cut rates will keep a lid on further appreciation in the AUD, and increases the likelihood that we have seen a peak for the AUD.

Forecasting More Declines Against Pound Sterling

With the AUD under so much pressure the underlying structure of the markets it trades in has shifted.

We have witnessed a notable technical event occurring against pound sterling in the first week of May that has us confident that the GBP to AUD will advance further against the Australian dollar.

The GBP/AUD managed to crack through the 100 day moving average - an area that had been proving a barrier to advances - which opens the door to a test of 2.0 once more.

2.0 in GBP/AUD appears to be a decent target from which those with an interest in buying Aussie dollars can place buy orders with their brokers.

Latest Pound / Australian Dollar Exchange Rates

United-Kingdom Australia
Live:

1.7973▼ -0.02%

12 Month Best:

1.9177

*Your Bank's Retail Rate

 

1.7362 - 1.7434

**Independent Specialist

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

Australian Dollar Now Most Vulnerable Currency in G10

The Australian dollar is now left particularly exposed to an US dollar which is looking increasingly intent on recovering the ground it has lost in 2016.

Indeed, the dollar was the best performing currency in the G10 space over the course of the first month of May.

This advance comes despite a notable miss on the much-anticipated release of employment data on Friday the 6th.

While the prospect of a June interest rate rise at the US Federal Reserve has been put to bed by the employment data, the dollar could well advance over coming days.

“Can the dollar still rise in the coming week?  Yes because the steady 0.3% increase in earnings and the uptick in year over year wage growth provides hope that retail sales, which fell sharply in March will rebound strongly in April,” says Kathy Lien at BK Asset Management.

The Australian dollar was hit hard after the Reserve Bank cut its inflation forecast by a whole percentage point and downgraded its assessment of the economy.

As we have noted already, this move not only explains the central bank's decision to cut interest rates in May but also fuelled speculation of more easing.

Citigroup's economiic researchers now estimate it may take up to 3 quarters before Australian inflation is back within the RBA’s 2-3% tolerance band, which potentially guarantees that further rate cut from the RBA.

“AUD is therefore seen to be more vulnerable to a turn in USD sentiment – which also makes it vulnerable on crosses such as sterling and euro which have recently found more resilience,” say Citi in a foreign exchange brief to clients.

However, there are likely to be limits to the currency’s weakness.

Westpac’s Sean Callow reckons that because the most recent set of US employment data came in below expectation the immediate threat of a notably higher US dollar has eased, limiting the downside for the Aussie.

“So another rate cut is likely to be driven mostly by further evidence of slowing inflation, with growth holding up OK. Near term, this should help AUD/USD stabilise ahead of 0.74. The US dollar looks soft enough near term to reinforce demand for AUD/USD on dips,” says Callow.

Those with Australian dollar purchase decisions should therefore be positioned for further AUD declines but be realistic as to just how far they will extend.

Don’t be greedy.