Australian Dollar to Decline as Rate Hike Outlook Fades

The Australian Dollar may continue to decline as the seemingly resilient economy betrays signs of weakness and the central bank’s rhetoric turns limp, hinting that interest rate hikes may be off the table for the months ahead.

A Credit Suisse gauge 1-year RBA rate hike expectations suffered a major setback last week, dropping 23.6% to show that traders now expect borrowing costs add 100 basis points over the next 12 months, down a hefty 31bps from the previous week. Furthermore, the priced-in probability of a rate increase in February (the next RBA policy meeting) declined to 41% versus a near-certain reading at 84% a week before.

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The downturn in the interest rate forecast seems well-grounded. Minutes from the Reserve Bank of Australia’s December meeting revealed that the central bank now reckons it has some “flexibility” on monetary policy having raised rates three consecutive times since October. Policymakers saw the arguments for the third increase as “finely balanced,” with the move to raise benchmark borrowing costs at 3.75% “materially shifting the stance of policy to a less accommodative setting.” Compounding this not-too-subtle shift away from hawkish rhetoric of recent months, the third-quarter GDP report proved disappointing as the antipodean economy managed to add just 0.2% (versus 0.4% expected). More worrying still, economic growth seemed to rest entirely on stimulus, as public spending surged 6.2% while private demand and exports floundered, leading investors to question how the apparent poster-child for economic rebound in the developed world will fare once the flow of government cash dries up.

The economic calendar offers no significant event risk, leaving the Australian Dollar in a precarious position with next to no other catalysts other than the tarnished interest rate outlook to frame directional momentum. To be fair, the Aussie remains sensitive to changes in risk appetite with the near-term correlation between the currency’s trade-weighted valued and the MSCI World Stock Index still at formidable 76.3%. However, range-bound stock markets didn’t do much to slow the bleeding for AUD as it led losses against its US counterpart last week, so it seems the yield story is a more significant catalyst for now.

Ilya Spivak