2010 Currency Outlook: AUD

In 2009, Australian dollar was the best performer among currencies in advanced economy as the country's economy was more resilient and avoided falling in recession during global financial and economic crisis last year. Moreover, the Reserve Bank of Australia was the first central bank in the world that increased interest rates 3 times last year.

Trade-weighted AUD surged +25.3% in 2009 after plummeting -19% in the prior year. Against individual currencies, AUD surged +47% against CAD, +30.1% against JPY, +26.8% against USD and +23.95 against EUR.

After a robust year, we expect the Australian dollar to lose it momentum in 2010 as interest differential been AUD and other currencies narrowed. Moreover, as the government unwinds stimulus measures, economic growth may decelerate.

Recent Selloff was More Severe than Expected

Reversal of AUD's rally started in mid-January and the decline was sharper than previously anticipated. Year-to-date, AUD plunged -2.16% against USD to 0.87 and -5.59% against JPY to 78.7. We believe factors catalyzing the situation were unexpected pause in RBA tightening, earlier-than-expected tightening in China as well as risk aversion triggered by US' bank proposal and sovereign crisis in peripheral European countries.

The RBA surprised the market by leaving the cash rate unchanged at 3.75% at the February meeting as policymakers would like to gauge the impacts of previous rate hikes on economic development. At the accompanying statement, the RBA realized domestic lenders 'have generally raised rates a little more than the cash rate over recent months and most loan rates have risen by close to a percentage point'. In December, the Deputy Governor Battellino said that it's 'reasonable to conclude that the overall stance of monetary policy is now back in the normal range' after lenders raised borrowing costs 'above their previous cyclical lows.

Moreover, earlier-than-expected cooling measures from China allowed RBA's actions to be less aggressive. On January 12, the People's Bank of China raised the deposit reserve requirement ratio (RRR) for commercial banks by +50 bps. This signaled the government's determination to contain inflation and more cooling policies to curb lending would follow. Australia and China are close trading partners. At previous meetings, the RBA stated 'growth in China has been very strong, which is having a significant impact on other economies in the region and on commodity markets'. Therefore, potential slowdown in China should be affecting Australia's economy.

Market sentiment has been seriously hurt recently as Obama's administration proposed a plant to curb risk-taking in banks. Moreover, Greece's budget deficit-to-GDP surged to 3 times above EU's limit. While the Greek government submitted a 3-year plan to reduce its debts, uncertainties on effectiveness and implementation remained. Worse still, contagion from Greece may engulf other European countries, evidenced in recent surge in CDS for debts in Spain, Portugal and Hungary.

Investors have become risk-averse and drained capitals from high-yield assets to USD and JPY. According to Commitments of Traders by the CFTC, net speculative long position in AUD has plunged dramatically over the past few weeks.

Monetary Policies: The RBA was in the midst of its tightening cycle in 3Q07, when Australia's economic growth began to moderate. During the period, inflationary pressure was strong. Headline CPI fell below 2% yoy in 3Q09 but then surged rapidly to as high as 5% yoy in 3Q09. Core CPI was also elevated. The central bank kept raising the policy rate until it reached 7.25% in March 2008.

Rapid economic slowdown in 2008 and early 2009 forced the RBA to lower interest rates. The easing cycle officially began in September 2008 when the central bank announced -25 bps cut in the cash rate. The easing process speeded up after Lehman Brothers went bankrupt and the RBA reduced the cash rate by -400 bps to 3% between October 2008 and April 2009.

As the Australian economy proved to be much less affected than other developed countries, the RBA delivered the first rate hike, by +25 bps, in October 2009. 2 more rate hikes in November and December, each by +25 bps, brought the policy rate to 3.75%.

Despite the unexpected pause in rate hike in February, the RBA has not ended the current tightening cycle. In February's meeting statement, the central bank said 'Interest rates to most borrowers nonetheless remain lower than average. If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term', indicating the upward bias in further interest rates. Consensus forecasts RBA's cash rate will reach 4.5-5% by end-2010.

What affects the currency outlook is the pace of rate hike, which in turns hinges on inflation outlook. After 3 consecutive rate hikes in late-2009, the RBA decided to wait and see for the impacts of previous tightening. While the RBA has turned more cautiously in raising interest rates, persistently high inflation should force another rate hike in coming months. In 4Q09, Australia's headline CPI rose +0.5% and +2.1% on quarterly and yearly basis respectively. Underlying inflation also remained well-above RBA's target of 2-3% at 3.4% on annual basis. The price index for 'non-tradable good' rose +2.6% yoy in 4Q09 from +2.3% a quarter ago, indicating strong domestic price pressure. The price index for 'non-tradable good' rose +2.6% yoy in 4Q09 from +2.3% a quarter ago, indicating strong domestic price pressure.

Economic Outlook: Australia's economy recovered more rapidly than its counterparts. Although GDP contracted -0.8% qoq in 4Q08, it went back to the positive territory in the next quarter, technically preventing the economy from falling into recession. Although expansion moderated in 3Q09, probably a result of rate hike and fiscal unwinding, growth momentum remained resilient and should pick up again in coming quarters.

At the February Statement on Monetary Policy, the RBA upgraded its forecasts on growth and inflation for the 3rd consecutive quarter, though the magnitude of upgrades was lower than in August and November. GDP growth is expected to reach +3.2% yoy by 4Q10, followed by +3.5% yoy in 4Q11. Headline inflation will expand +2.5% yoy in 4Q10 and then by +2.75% in 4Q11.

The latest employment report shows that the number of payrolls rose +52.7K in January, following an increase of +37.5K in the prior month. Unemployment rate fell for the 3rd consecutive month to 5.3%. Encouraging recovery in the job market should support consumer spending. We see the central bank's expansionary measures should not last for long.

Although our AUDUSD forecast suggests the currency pair will be stable throughout the year, volatility cannot be ruled out as driven by policy uncertainty, not only in Australia but all over the world. The chart below shows high inverse correlation between Aussie and USD Index. If USD's strength persists because of tightening by the FED or reduction in risk appetite, AUD should risk going lower.

2010 Forecast Table - AUD