We look for AUD/USD to fall to USD0.68 in late-2019, then to USD0.66 in early-2020.

Since our last Market Outlook, the Australian dollar has again traded a tight range. From USD0.6999 a month ago, the currency fell to a low of USD0.6868 briefly before quickly rallying back above USD0.69, now 0.6960. US/Australian interest rate differentials and commodity prices remain key for valuation.

Beginning with the RBA, the past month has seen the RBA cut the cash rate to 1.25% and expectations of further easing build. As detailed on page 6, on 24 May Westpac Economics added a third cut to our RBA call, to take the cash rate down to 0.75% in November. The market has also now priced in three cuts in this cycle, though not until mid-2020 – the expected cash rate at June 2020 falling from 1.00% a month ago to 0.73% currently.

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A shift in expectations like this would typically weigh heavily on a nation’s currency. Why not on this occasion? In part because of commodity price strength (more below), but also as US interest rate expectations have moved further than our own.

For the FOMC, a month ago two cuts (to a fed funds rate of 1.875%) were priced in by the September 2020 meeting. Now, almost four cuts (89bps) are expected by November 2020. Moreover, spreads at the long end of the yield curve have also narrowed, from –73bps to –68bps for the 10-year yield. The cause of this abrupt shift in US policy expectations is detailed on page 18. In short, whereas the world previously believed President Trump’s trade disputes would be resolved in short order, after repeated escalations, they now see no end in sight. Consequently, there is cause to be concerned over US growth, foremostly business investment but, if not offset by policy, also household spending.

Looking ahead, while we now expect the FOMC to cut the federal funds rate twice in 2019 (in September and December), the current market expectation of essentially another two cuts in 2020 is, to us, unwarranted. Therefore, with the market having priced too many cuts in for the US and still yet to bring the timeline of the remaining two cuts for this RBA cycle into line with ours, we expect the Australian dollar to depreciate in coming months.

From USD0.6960 currently, we look for our currency to fall to around USD0.68 in the second half of 2019, then to USD0.66 in the first half of 2020. The pall over Australia’s economic outlook is thicker and slower moving than the US, and so only a very modest lift in the second half of 2020 can be expected – to USD0.67.

Obviously, for exchange rates, interest rates are not the only explanatory variable. For Australia in particular, commodities are also key. On this front, price movements continue to be dictated by the supply side. This is particularly the case for iron ore, owing to the tragic developments in Brazil earlier this year. Having risen above USD$100/t in mid May, 62%fe iron ore in early June was around US$99/t.

Though global supply is expected to increase in coming months, it will be slow in coming to market. Along with an expectation that run-down inventories will be partially rebuilt, and as Chinese authorities continue to stimulate a lift in infrastructure and construction activity, the slow response of supply should see the price of high-quality iron ore only slowly retreat – to US$95/t December 2019; US$80 June 2020; then $US65 December 2020. Also held up by supply-side issues, coal prices are set to remain at elevated levels over the forecast horizon.

If it were not for the above sustained strength in commodity prices, all else equal, the Australian dollar would be much lower and set to remain that way over the forecast horizon – particularly given the benefit elevated commodity prices are currently offering our governments’ budgets, and in turn public investment and GDP.

A final point then on capital flows after the release of the latest Balance of Payments. In recent years, Australia has not only experienced robust demand from diversified foreign investors, but also from entities looking to make a concentrated ‘direct’ investment which gives them partial or complete control over a whole asset (both companies and buildings).

However, in the three months to March 2019, the direct investment flow looks to have come to a halt. Versus the $79bn inflow of 2018, the most-recent quarter saw a annualised net direct inflow of just $3.2bn. In part, this was because Australian firms invested more offshore in the quarter. But, given growth fundamentals and the outsized gains of recent years, it seems appropriate to assume that future direct inflows will be materially smaller than the past seven years. This points to the end of an extraordinary support for the Australian dollar and, as a result, our currency becoming more susceptible to downside shocks.

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