Photographer: Jack Atley/Bloomberg

Here's Why The Aussie Dollar Is Even Stronger Than You Might Think

Are markets under-pricing the risk of another rate cut?

On the surface, Australia's currency recently played its traditional shock absorber role to perfection: it dropped four U.S. cents in the 10 days following Donald Trump's shock victory.

But pushing beyond the greenback and comparing the exchange rate with some of Australia's top trading partners' finds a more worrying picture. Against China's, Japan's and South Korea's currencies, the Aussie has been appreciating strongly. James McIntyre, head of economic research at Macquarie Bank Ltd., reckons it's trading against the yuan at the equivalent of about 84 U.S. cents -- 10 cents above its current level.

``We've got a strong currency, it's just been hidden because of the focus on the U.S. dollar exchange rate,'' McIntyre said, noting that against a basket of exchange rates, the Aussie is above the level assumed in the Reserve Bank of Australia's November update of its growth and inflation forecasts.  ``The currency's gone from helping the economy to complicating its adjustment, as the RBA would put it.''

Given China and Japan are Australia's top two trading partners, one risk is the currency's strength will cut import prices and further compress Australia's already weak inflation.

But there's another problem. Macquarie says signs have emerged that Australia's economy has gone back to importing some services, which it had started producing at home and boosting employment in the process: the opposite of what policy makers are intending.

That then raises the question of whether markets are under-pricing the risk -- a maximum 15 percent chance next year -- that the RBA will need to ease monetary policy again to offset the impact of the currency. It could also reduce the likelihood of an interest-rate increase that's been the topic of some discussion.

Australia's economy shrank in the three months through September, just its fourth quarterly contraction since the last recession in 1991. While there were several one-off reasons for the slump that are unlikely to be repeated, McIntyre said there was more to it.

``We would be remiss to overlook the impact the strengthening of the currency, especially since the middle of the year, is having in terms of these tradeable sectors of the economy,'' he said.

Tony Morriss, an interest-rate strategist in Sydney at Bank of America Merrill Lynch, said Australia's central bank is likely to leave rates on hold ``for an extended period'' and the key factors to watch next year include the Aussie dollar and commodities.

``Domestic economic conditions will remain frail next year,''  said Morriss, who predicts core inflation will hold below the RBA's 2 percent to 3 percent target band until 2018.  ``Currency appreciation would be detrimental to key drivers of growth in the trade-exposed sectors.'' 


((For more economic analysis, see Benchmark))
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