Australian Dollar: S&P Downgrade is Clear Warning Signal, Deutsche and BNP Paribas Forecast Declines

S&P have downgraded Australian debt - but will it dampen investor desire to seek out the country’s superior interest rate yield and therefore the attractiveness of the Australian dollar to international investors?

The Australian dollar has endured a down day against both the British pound and US dollar after S&P announced it was downgrading the outlook for the country's AAA debt to negative from stable.

S&P cited the current impasse in Australian politics as a key factor weighing on the country's finances as it grapples with controlling its fiscal deficit.

The pound to Australian dollar exchange rate (GBP/AUD) bounced higher to 1.7291 while the Australian to US dollar exchange rate (AUD/USD) moved lower to 0.7517.

The final composition of the next government is not yet known but it does seem that the current coalition arrangement will prevail.

Nevertheless, the ability to push often unsavoury, yet necessary, fiscal decisions through parliament will continue to be a struggle.

"The negative outlook on Australia reflects our view that without the implementation of more forceful fiscal policy decisions, material government budget deficits may persist for several years with little improvement. Ongoing budget deficits may become incompatible with Australia's high level of external indebtedness and therefore inconsistent with a 'AAA' rating,” S&P said.

ANZ Research say it difficult to call S&P’s decision to put Australia’s AAA sovereign rating on negative-watch a surprise.

Speculation around the credit rating has escalated over recent years, with the lack of significant delivered fiscal reform and an increasingly fractious political environment contributing to a growing sense that movement on the rating was more a question of ‘when’ rather than ‘if’.

"While this complicates the policy environment, and talking about what should happen is easy enough, the reality now is that the room for manoeuvre is diminishing. Today’s announcement from S&P is the first concrete warning signal. It is calling for a shift in approach," say ANZ.

The Australian currency fell in the wake of the announcement.

“Until there is some clarity on the political front we can expect the budgetary backdrop to remain unclear. Amidst ongoing signs of a deceleration in activity the pressure upon the RBA to move is set to build, underlining a negative AUD bias,” says Jeremy Stretch at CIBC Markets.

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However, the currency is unlikely to stay low for long as yield-hungry investors will remain attracted to the high yield that Australian interest rates present.

In a world starved of yield owing to record-low interest rates at the world’s biggest central banks, Australia and New Zealand stand out.

With a 2% basic rate in Australia and a 2.25% basic rate in New Zealand

The attraction of borrowing at incredibly low rates in the UK, US, Japan and Eurozone and depositing that money in high-yielding financial vehicles in Australia and New Zealand remains compelling.

Deutsche Bank See 3% Fall in AUD vs USD

Despite the underpinnings provided by the country’s high yield, Deutsche Bank have confirmed to clients they hold a negative outlook on the currency.

“As the dust falls on political events in Europe and investors look up, the case to be short AUD is even stronger than before,” says Deutsche’s Robin Winkler, “domestically, the political gridlock that will likely result from Saturday’s inconclusive elections could have two consequences.”

First, says Winkler, it makes corporate tax cuts less likely and could dampen business confidence.

Second, Australia now looks set to lose its AAA credit rating, which already started with S&P lowering its outlook on the country's debt to negative.

Externally, China’s systematic devaluation in the past weeks has not yet raised alarm bells.

However, Chinese devaluation should renew the pressure on the commodities complex. A weaker RMB lowers breakeven prices for Chinese high-cost producers and thus delays necessary supply-side adjustments.

“As a consequence, we continue to see iron prices falling to the low $40s in the second half of the year to equilibrate the market. All things constant, this move alone would be worth ~3% downside in AUD/USD,” says Winkler.

Meanwhile, BNP Paribas have used the move by S&P to reaffirm their bearish view on the AUD and target a move to 0.67 by year-end in AUDUSD.

"The current fragile risk environment should not be supportive for G10 commodity exporter currencies," says a note from BNP Paribas. "Furthermore, our economists expect the RBA to cut rates by 25bp at their next meeting on 2 August, a view now 60% priced into rates markets."

The key policy consideration for the RBA is likely that inflationary pressures remain soft and analysts think Q2 CPI data (released 27 June) is will print in line with the RBA’s 1.0% y/y forecast which would be enough to prompt a rate cut

BNP Paribas' medium-term forecasting model BNP Paribas CLEER™ also signals downside in AUDUSD below 70 cents this year.