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The Australian Dollar is Forecast to Suffer a 7.5% Loss vs. the Pound in 2018 According to one Analyst

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Expectations for GBP/AUD in 2018 range from a 7.5% loss to a 5% gain - the outcome will however ultimately depend on Australian inflation dynamics.

The Australian Dollar’s fortunes will be dictated in the year ahead by a mixture of domestic risks to the currency and excessive US Dollar weakness, according to strategists at Credit Suisse and Commerzbank, although both banks differ markedly on where the Aussie currency will sit come year-end.

Of particular concern to analysts at both institutions is what happens to Australian inflation, as price dynamics are the foremost concern of the Reserve Bank of Australia which of course set the all-important interest rate.

We find assumptions on inflation vary, and therefore help explain divergent forecasts for the Aussie which has thus far endured a lacklustre year of trade with the only periods of brightness coming against a weak US Dollar.

Australia’s Dollar has risen by half a percent against the US Dollar in 2017, but has fallen 2.0% against the Euro. Against the Pound, we note losses too with the Pound-to-Australian Dollar falling nearly 3% to reach 1.7734. .

Indeed, the outlook appears to be clouded by a litany of domestic and international risks that will be as relevant as ever for the Aussie currency this year.

“We continue to favour G10 low yielders like CHF and JPY to high yielders like AUD and NZD,” says Shahab Jalinoos, an FX strategist at Credit Suisse.

In the current environment of quickening global economic growth, and anticipated increases in global interest rates, the Reserve Bank of Australia’s inflation outlook and its attitude toward the Australian Dollar will be of increased importance to the Aussie in 2018.

Traditionally, currencies like the Aussie and New Zealand Dollars have enjoyed substantial support from the yields offered by their respective government bonds, which have always been relatively generous when compared with those of other developed economies such as the US and UK.

However, with interest rates expected to rise rapidly in the US and Canada, as well as to some extent in the UK and possibly even Europe, this yield premium could shrink over the coming quarters if the RBA does not also begin to look at raising interest rates.

This dynamic should therefore disadvantage the Australian Dollar.

Above: AUD/USD exchange rate shown at weekly intervals.

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It's All About the Inflation Outlook

The Reserve Bank has held the Australian cash rate steady at a record low of 1.5% for 18 months in a row and pricing in interest rate markets currently suggests that investors and traders do not expect it to change the rate until early 2019.

Some fear this will have adverse consequences for the Australian currency, given that changes in relative interest rates are among the most powerful drivers of capital flows into and out of currencies on the international market.

“We see limited scope for RBA tightening expectations to pick up in near-term, data does not support it. In absence of inflation pressures, elevated household leverage is likely to keep the RBA cautious,” says Jalinoos.

Returning inflation into the target band is therefore important for the Australian currency because interest rates can only rise or fall when changes in inflation command it; hence Credit Suisse's pessimistic view on the Australian Dollar in 2018.

Australian inflation remained stubbornly below the RBA’s 2% to 3% target in the fourth quarter, when markets had hoped for a small rise from 1.9% to 2%. This was the second consecutive quarter that inflation pressures surprised on the downside.

“Inflation rate developments also point towards the RBA continuing its cautious approach,” says Thu Lan Nguyen, an analyst at Commerzbank. “After inflation remained below the central bank’s target range of 2-3% for two years it had risen to above 2% again for the first time in early 2017. However, this price rise was short-lived.”

One source of the downward pressure on Australian inflation has been lacklustre wage growth and the resulting weaknesses in consumer spending and household balance sheets.

“Even though the prospects for the Australian labour market are positive [the RBA] assumes that wages will continue to rise only slowly, which means that inflation too will only slowly reach its target,” says Nguyen. “We too assume that it will only stabilise in the RBA’s target range in the second half of this year.”

Another source of downward pressure on the inflation has been, and could continue to be, the multi-year recovery in the Australian Dollar, because a stronger currency reduces domestic inflation by making imports cheaper to buy.

“The RBA will take its time with the normalisation of its monetary policy, not least in order to avoid a stronger appreciation of the AUD, which could jeopardise the achievement of its inflation target,” Nguyen adds.

This downward pressure could quite easily be exacerbated by any further excessive weakness in the US Dollar over the course of 2018, which is why strategists so often warn of “verbal interventions” from the RBA that could push the Aussie currency lower.

“If AUD/USD should establish itself well above the 0.80 level on a sustainable basis in the foreseeable future, it is likely that the RBA will intensify its verbal interventions again at one of their next meetings in order to avoid risking downward pressure on the inflation rate due to the strong currency,” Nguyen also warns.

 

Australian Dollar Forecasts vs. the Pound and Dollar

Despite the risks, Commerzbank’s FX team forecasts a steady increase in Australian inflation throughout 2018, which is expected to drive a gradual change in the RBA’s language before culminating in an interest rate rise “sometime in the second half of this year”.

As a result, they predict a further increase for the Australian Dollar in 2018, which should push the AUD/USD rate up to 0.8200, which would be its highest level since January 2015 and implies 4.2% upside from Wednesday’s level of 0.7625.

Commerzbank’s forecast for a Pound-to-US Dollar exchange rate of 1.34 at year end, combined with the AUD/USD projection, suggests the FX team expects the Pound-to-Australian Dollar rate will finish 2018 around 1.6341. This implies 7.5% downside for the Sterling-Aussie rate in 2018.

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

The Credit Suisse have a more pessimistic view of the Australian Dollar’s prospects in 2018 which, when combined with their relatively positive outlook for the Pound-Dollar rate, bodes well for Sterling-Aussie.

They predict the AUD/USD exchange rate will finish 2018 at around its current level of 0.7800 and that the Pound-Dollar will close the year at 1.4500, which leaves the Sterling-Aussie rate around 1.8500. This implies around 5% upside for the British Pound to Australian Dollar rate.

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