An overview of key market dynamics
We have lowered our forecast for AUD in 2022 but maintain an upbeat view for 2023. Central banks’ success in returning inflation to target will be the key.
This week we released our September Market Outlook.
In the document we have significantly revised down our forecast for the AUD/USD by year’s end from USD0.73 to USD0.69.
However, we maintain our upbeat view for AUD in 2023 expecting a six cent recovery to USD0.75 by end 2023. The bulk of that recovery is expected in the second half of 2023.
The basis of our positive outlook for AUD in 2022 had been around our expectation that the sharp slowdown we are now observing in the US economy would weigh on the US dollar. We had also expected that markets would respond to an improving outlook for the Chinese economy in the second half of 2022, providing a positive confidence base for the Australian dollar.
With Australia’s commodity price Index currently above those levels when the AUD was previously trading above parity with the USD, we also anticipated some tail wind from our extraordinary trade performance in 2022.
Clearly these factors are going to be outweighed by a much more aggressive US FOMC than had been our expectation (with the fed funds rate now likely to peak materially higher than we previously anticipated); as well as ongoing setbacks with the zero Covid policy in China and its parlous property market, (although there is encouraging evidence that the Chinese authorities are now addressing the issue).
Because Australia’s outperformance on commodity prices is centred on fossil fuels markets are heavily discounting our trade performance, in particular questioning whether the current terms of trade surge will be followed by the style of mining investment boom that we saw during the early 2010’s.
Over the course of the remainder of 2022, we expect extreme volatility in the AUD/USD around that USD0.69 track as the supercharged USD is challenged and the efforts from the Chinese authorities to revitalise the Chinese economy continue apace.
But the dominant headwind for a risk currency like the AUD will be ongoing uncertainty in 2022 – uncertainty about the level and timing of the peak in central bank interest rates (especially the FOMC), and uncertainty about the global inflation profile.
As we move through 2023, inflation will peak; central banks will go on hold and those uncertainties will ease. Despite the developed economies slowing materially, markets will be looking towards the next easing cycles which we anticipate for 2024 in both US and Australia.
We envisage similar developments in debt markets where bond rates will fall in response to clarity around inflation and central banks’ holding the line.
This scenario does depend heavily on the demand related sources of inflation easing in line with the rebalancing of supply shocks which is already well underway.
Central banks understand that demand (with the clear exception of China) needs to be flattened in 2023 to squeeze the inflationary animal spirits out of the system. If businesses, who are now finding that the scope to raise prices and lift wages is building, expect this flexibility to continue then prospects for an orderly wind back in inflation in 2023 will disappear.
Central banks need to do enough in 2022 to ensure that flat outcome for demand in 2023.
In that regard we have recently lifted our forecast for the peak in the federal funds rate to 4.125% from 3.375% and confirm our forecast of a peak in the RBA cash rate of 3.35% which has been somewhat higher than most analysts.
In the September Market Outlook, we lowered our growth forecast for the US economy in 2023 to 0.6% and confirmed our forecast for growth in Australia in 2023 of 1%.
In the case of Australia, arguably, we can be more confident about the 1% growth view than the 3.35% cash rate peak. If it turns out that the RBA is convinced that a higher terminal cash rate will be required to achieve that desired slowdown in demand, then I expect it will eventually move in that direction.
The aftermath of Covid has created unusual circumstances for calibrating that link between monetary policy and growth/inflation.
- Policy was forced to move so far away from neutral during Covid and the required rapid move back to neutral means that “treacherous lags” have built up in the system complicating the calibrating of the impact of policy on demand (e.g. banks have only passed on the first 75 basis points of the 225 basis points of rate hikes so far).
- The household sector has accumulated around $275 billion in “excess” savings during the pandemic raising the risk that activity will be more resistant to policy tightening than in other cycles.
- Due to the collapse in net migration during Covid and the pent-up demand following the reopening, labour markets are uncharacteristically tight at this stage of the tightening cycle.
We expect the best policy is to slow the pace of tightening back to 25 basis point increments to allow time for an assessment of these various forces but, given that the objective is to “short circuit” these inflationary animal spirits, the risk is that a slowdown will lead to a questioning of the commitment of the RBA to complete the job.
We saw a “flavour” of those dynamics in the September Consumer Sentiment survey, where Sentiment rebounded by 3.9% to 84.4 and House Price Expectations lifted by a surprising 3.6%.
We put the overall lift in Sentiment down to a natural floor for the Index given that the 80 level (it reached 81.2 in August) had only been sustainably breached during the deep recession of the early 1990’s while the lift in House Price Expectations looks to be unsustainable.
But the real message is that the RBA has significantly more work to do.
We expect rate hikes at the next four meetings out to February next year, with tough associated language moving more into line with the themes from the Fed Chair Powell at Jackson Hole than the more conciliatory approach currently being taken by the RBA Governor.
That approach might risk even higher interest rates if those inflationary animal spirits are not tamed as soon as possible.
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