Aussie Dollar: Some Fresh Bad News to Contend With

Things are going from bad to worse for the Australian dollar. The currency had already lost its footing under the weight of (1) a broad-based US dollar advance (2) a sharp decline in portfolio flows into Australia (3) greater tolerance of slower growth in China and (4) fears over where Australian growth will come from once mining investment peaks, then recedes.

Now upstream inflationary pressures are subsiding too. PPI inflation in Q2 dropped to 1.2% y/y (prev. 1.6%), sending AUD/USD sub-0.89. This reinforces the RBA’s view that plenty scope remains for further policy easing.

Another 25 bp cut from the RBA on Tuesday is almost universally expected.

It’s nearly fully priced in though, so what additional currency weakness could flow from this decision next week? We are watching for three things:

1. Policy bias: If the RBA maintains an explicit easing bias in the policy statement, AUDUSD will likely pay the price for that.
2. Pass-through to borrowing costs: Chart 1 shows that the real economy has not always benefited fully from previous RBA cuts. The latest easing cycle began in Nov 2011, but mortgage interest rates have fallen at a slower pace. Intense competition for fresh deposits has pushed up bank funding costs.

If the RBA eases, and if the cut is not passed on in full, AUDUSD will likely suffer due to the increased risk of further RBA easing.
3. Prospects for rebalancing: The looming peak in mining investment has been on RBA radars for at least a year, along with the need for economic rebalancing to deal with the aftermath. Can this transition be managed smoothly? RBA rhetoric on that question has gone from sounding optimistic, to merely hopeful lately.

Next week the tone could switch again to communicate a degree of concern − unless the currency were to assist this transition by weakening further. Any comments to that effect would likely add to selling pressure on the currency.