Higher commodity prices could push the Australian dollar above the Commonwealth Bank’s year-end forecast of 73 US cents, according to chief currency strategist Richard Grace.
As prices of the nation’s two largest exports – iron ore and coal – soar, Australia’s international trade deficit is expected to narrow significantly over the coming months. That would narrow the country’s current account deficit, which would in turn support a higher valuation of the local currency, Grace said in a note on 21 October.
“[T]here is a large risk that AUD/USD is higher than our long-held view of 0.7300 by year-end, particularly if the outcome of Australia's Q3 [third-quarter] inflation number means the RBA [Reserve Bank of Australia] refrains from cutting interest rates at their November meeting,” Grace said.
“AUD is set to be well supported by the dramatic improvements in Australia's trade deficit, and moderate improvements in Australia's current account deficit and terms of trade,” he said.
The Australian dollar has advanced 4.1% against the greenback this year to 75.87 US cents at 10:17am Sydney time today. The Aussie was up 6.6% over the past year, making it the third best performer among the 16 major currencies, according to Bloomberg data.
Over 12 months, the Aussie hit its lowest at 68.64 US cents on 15 January, and traded at the highest level of 78.13 US cents on 19 April.
Notably, the Australian dollar has traded above its 12-month trading range against the US dollar, euro, Swiss franc and Chinese offshore yuan, and will remain towards the top-end for the near term, Grace pointed out. "[R]eaders should not expect a large near-term depreciation in AUD, but rather brace for the risk of more upside in AUD."
Terms of trade is the ratio of a country’s export prices to its import prices, and is useful in evaluating the outlook for its currency.
Data yesterday showed the country’s import prices fell 1% in the September quarter, while export prices rose 3.5%. Based on these, third-quarter terms of trade is expected to increase by about 4.5%, CommSec chief economist Craig James said.
“If export prices are outpacing the price of imports, this indicates a broad-based lift to incomes in Australia,” said James.
He pointed out that commodities such as sugar, beef, gold, gas and metals recorded solid prices gains in the third quarter, in addition to iron ore and coal.
Iron ore and coal, which collectively account for 26% of Australia’s total exports, have rallied since the beginning of July, amid closures of loss-making commodity producers in China.
Coking coal and thermal coal have jumped more than 50% and 35% respectively, while iron ore has climbed more than 10%, Grace said.
“It is important to recognise that the trade-weighted appreciation in AUD would not have been so strong if economic growth in Asia was weak.
“To be precise, Asian GDP [gross domestic product] growth is below-trend, but relatively firm. Reflecting firm Asian demand, the volume of Australia’s resource exports continues to break record highs,” he said.
Inflation and cash rate
CommBank’s AUD/USD end-2016 estimate of 73 cents was based on assumptions that the Reserve Bank of Australia (RBA) might cut the official cash rate next week, while the US Federal Reserve might raise its interest rates in December.
The latest quarterly inflation data, out on Wednesday, is a key indicator to gauge the RBA’s next move. Australia’s Consumer Price Index for the three months to September rose 0.7%, higher than economists’ estimate, which helped lift the annual inflation rate to 1.3% from a 17-year low of 1%.
That inflation data has reduced the likelihood of RBA cutting the cash rate next week, as seen in the Australian Securities Exchange RBA Rate Indicator.
“Our recent observation is that incremental central banks rate cuts in response to low inflation tend not to put too much sustained downward pressure on the exchange rate,” said Grace.
At the close of trading on 27 October, investors priced in a 94% chance of no change to the cash rate in November, compared with an 84% chance before the inflation data was published.
The RBA Rate Indicator measures market expectations based on prices in the ASX 30-Day Interbank Cash Rate Futures.
Having said that, a reduction in the cash rate “can’t be completely ruled out” as inflation remains lower than the central bank’s target range of 2% to 3%, James said in a separate note on 26 October.
“But higher food prices and higher commodity prices have the potential to lift headline inflation, inflation expectations and thus underlying inflation,” he said.