The RBA outlook towards the Aussie trading levels?

Jonathan Cavenagh, Currency Strategist at Westpac , on Australian economy and AUD

Lately, a big worry for Australia's economy has been China's property and construction market. At the moment it slows down too rapidly and it could hurt Chinese commodity demand, economic activity and eventually, this would have implications not only for Australia, but also the world. Do you believe these problems in China could significantly hurt the Australian economy and its currency? And do you think that there is something to be done from Chinese official’s side?

I believe that slowdown in Chinese property sector has certainly laid on commodity demand in over the past six months, but there has also been a fairly strong uptick in supply. Hence, the major global resource companies are increasing supply to the market. At the same time demand has softened, it had an increased supply response as well. This is a pretty bad kind of mix for prices, and that is the key reason why we have seen such a rapid fall in prices, particularly for things like iron ore and coal, over the past six months. That has seen as an export commodity basket and as Australia’s terms of trade fall also. Therefore, in the last two quarters we have witnessed the country’s income growth on some measures contract for two consecutive quarters. So, number of people has spoken about the need for a response to the given situation and there is a high probability for it to come from both Chinese and Australian sides.

We anticipate that Chinese authorities are going to be looking to do more to support their economy. We have seen one interest rate cut recently, but more stimulus is likely to be on its way today. A certain report of the authorities stated they are looking to boost lending in 2015 and make it easier for small and medium size enterprises to access funding. That should help stabilize Australian housing market sentiment, and ultimately contribute in putting off somewhat the floor on the commodity prices. However, we still think there is a risk that the RBA has to cut interest rates in Q1 of next year, in order to keep the outlook for Australia reasonably close to trend pace of economic growth. Thus, that should still potentially weigh on the currency over the next 2-3 months.

RBA says the Australian Dollar needs to fall further, in order to boost the national economy to desirable levels. Moreover, the central bank seems hopeful that US interest rates may rise sooner than most expect, which would put further downward pressure on the Aussie. Taking into account that further greenback strengthening may be offset by increased monetary stimulus in Japan, still Australia's second largest export destination, which has pushed the Yen lower, do you agree with the RBA outlook towards the Aussie trading levels?

We understand the reason behind the RBA willingness to have a weaker currency.

That is going to help with the economic re-balancing story, thus, a weaker Aussie will make exports more competitive, whereas the manufacturing, tourism and educational sectors will start to do better as well. Moreover, it should certainly help offset some of the damage done by the lower terms of trade and a weaker backdrop from some of the major trading partners with the decline in mining investment. Therefore, we have a lot of sympathy for the RBA view and traditionally the AUD/USD does move in line with commodity prices.

The Aussie is still probably a little bit overvalued even at the current levels relative to where commodity prices suggest it should be, so we believe there is a risk we can get down towards the 0.79-0.86 against the USD and the RBA wants to see the Japanese capital inflow story turning things around too dramatically. If the economic recovery is not strong enough even with a weaker exchange rate, then we still expect they are going to be forced to cut interest rate in Q1 of 2015.

Alongside the commodity prices and the anticipated rate cut, what factors should be considered as the core drivers for the Aussie throughout the Q1 of 2015?

I would like to mention that outlook on the Greenback will also have quite a significant impact, and all of the 3 key factors will largely determine where the AUD trends. At this stage, we believe the US Dollar is generally going to remain on quite a firm footing, particularly against the Euro and the Japanese Yen. Thus, that should probably work to weaken the Aussie, whereas commodity prices are going to move sideways from their current levels before moving higher into the second half of 2015, as Chinese growth and global economic activity look better. Hence, while commodity prices in the first quarter of 2015 may be as negative as they have been over the past three to six months, we do not expect it to positively impact the currency at this stage.

What are your forecasts for AUD/USD, EUR/AUD and AUD/JPY for the end of 2014 and Q1 of 2015?

We expect the AUD/USD currency pair to trade at 0.82 levels by the end of Q1 of 2015. Talking about the AUD/JPY we see the pair at 101 and we anticipate that the Euro will touch the 0.6068 level versus the Australian Dollar in Q1 of 2015.