The first of three notable rate decisions this week is scheduled to cross the wires during today’s Asian session. Both market participants and commentators generally expect the Reserve Bank of Australia (RBA) to hold its benchmark lending rate unchanged at 3.00 percent for a fourth consecutive month. However, like any other asset, the Australian dollar is guided by speculation.
The market will look to confirm that there is in fact no change to rates and absorb the commentary that accompanies the announcement to derive the timing for what many believe is the inevitable turn to a hawkish rate regime. This is a unique position for any currency to be in considering the global recession and financial hardships; but it is particularly unusual for one backed by a surprisingly strong economy with an already high benchmark rate when risk appetite is extraordinary volatility.
[B]What to Look For[/B]
Despite the economy’s ability to avoid the stigma of the ‘recession’ label and the government’s comparatively tame stimulus program, there is little chance that the central bank will announce a change from the wait-and-see policy stance it has maintained since May. From a fundamental perspective, the economy was able to skirt a contraction; but the economy is still struggling to maintain and revive positive expansion. Foreign demand for Australian exports has naturally been depressed by the global recession. With production in China and many other trade partners stifled by the broader slump in activity, demand for raw materials from Australia has in turn been dampened. Domestic demand has so far filled the gap; but Australia can still catch the global cold as the pain in the export sector filters down into capital investment and employment. Another reason to believe RBA Governor Glenn Stevens and his fellow central bankers will decide to hold rates is the relatively tame level of headline inflation. Price growth in the government’s consumer basket slowed to a 1.5 percent annual pace in the second quarter from 2.5 percent over the first three months of the year. This is actually below the target 2 to 3 percent band.
Taking stock of the consensus that will be used to benchmark this event, all of the economists polled by Bloomberg see no change coming from this meeting. More important from a market reaction point of view, Credit Suisse overnight index swaps are pricing in virtually no possibility of a hike.
Does this mean that the rate decision will be a non-event? Not necessarily. Market participants are active speculators; and the hint of any time frame for a return to rate hikes (or less likely, another round of cuts) can be just as market moving for the currency market than a foreseen shift itself. Any commentary that is released alongside the decision will be fully discounted by the yield-hungry market. Just this past week, Governor Stevens paved the way for a hawkish regime to take over in the not-too-distant future when he said the economy was performing better than initially projected and he never heard “in discussion some rule of thumb that says we wait until unemployment is peaking before we lift the cash rate.” This is among the most hawkish commentary we have heard from any central bank in years. Anything to further these comments will be considered bullish confirmation.
[B]Current Conditions vs. Speculation[/B]
To illustrate the point that speculation plays a heavy role in guiding price action, we have two graphs below. The first compares AUDUSD spot price action (orange line) with the spread between Australian and US 3-month Libor rates (blue line). There is an undeniable link between the two; but there is a clear divergence since March to April of this year. This takes into account a very important factor: risk appetite. At the same time that the exchange rate diverges from the path of the yield differential, we were witnessing a rebound in risk appetite was tangible in equities, commodities, fixed income and of course FX. Adjusting from real rates to expected rates, we can see that risk appetite has taken control. The second graph compares AUDUSD spot (orange line) to the difference between one year overnight index swap rates for Australia and the US. Here, we see a far more responsive correlation that accounts for risk appetite’s influence on market conditions.
So now that we have a bearing on what to look for from the RBA rate decision and how risk appetite will define the market’s reaction; we need to match the outlook to an outlook for AUDUSD. We have seen a substantial bull wave from this pair since March; but the most recent leg of the rise has developed just over the past four weeks. This is a move that has been largely based on the impressive results of the second quarter US earnings session’ and then the US dollar’s tumble plunge to new lows for the year. The US dollar is backed by well-founded expectations that the Federal Reserve will hold its own benchmark lending rate at its range from 0.00 to 0.25 percent until the middle of next year. This not only allows the market to respond to the Aussie dollar’s strength; but it actually amplifies it. However, much of the rate forecast has already been priced in at this point; so there is likely a greater premium on risk appetite to continually feed the advance of AUDUSD. If the RBA’s commentary is disappointing and risk appetite generally cools over the next 12 hours, we could see potential resistance in 0.85 grow more ominous.