AUD Set to Weaken Over the Coming Months

AUD Set to Weaken Over the Coming Months

 Published: September 14th, 2022

The Australian Dollar (AUD) is on a weaker trajectory that could see declines in Q4 2022 and Q1 2023. The prediction by independent London research house Capital Economics points to two factors likely to weigh on the Aussie.

The first is the country's cooling housing market. The second is a breakdown in the country's balance of trade exports to China start to slow down.

‘We believe Australia’s balance of trade will degrade somewhat as the Chinese economy, and its property sector in particular, continues to slow down,’ said the firm in a research note.

The ebb and flow of Chinese demand remains a crucial driver of economic fortunes down under, as it is the primary destination for Australian exports. If China's economy starts to slow down, it could negatively affect Australia's own growth forecasts.

Capital Economics says the volume of commodity exports like iron ore are expected to fall, even as soon as October if current trends continue.

The dour predictions arrive just as AUD solidifies its reputation as one of 2022's top-performing currencies. Only the mighty Greenback and Canadian Loonie have performed better.

According to some analysts, part of AUD’s outperformance is down to spiking commodity prices, which have been aggravated by Russia's invasion of Ukraine, the squeeze on energy supplies caused by Western sanctions, and ensuing supply chain disruption.

Housing sector fortunes could be definitive for AUD

Capital Economics does believe the Aussie ‘hasn’t seen the benefits you would normally expect from the improvement in its balance of trade seen in recent years.'

‘That is probably because of offsetting factors such as shifting yield differentials. As that dynamic isn't providing much support, we believe addition falls in commodity prices will pull the Aussie downward.’

A cooling market in residential housing starts and mortgages is also expected to weigh on AUD as the knock-on affects of recent Reserve Bank of Australia (RBA) rate hikes make themselves felt across key sectors.

‘There are unmistakable signs that Australia’s housing sector is starting to slow. Residential construction has dropped by almost seven per cent in Q2 2022, quarter over quarter. Supply shortages may be oartky the cause, but the sector is also sensitive to rises in the interest rate. As house prices fell in August at their fastest rate since 1983, we believe it won’t be long before the broader sector finds itself in an extended slump.’

Investors may be underestimating how soon RBA rate hikes will be reversed, the firm suggests, if central bankers in Sydney are forced to respond to a housing market meltdown.

‘If the experience of past housing downturns is any guide, we believe the RBA will reverse course next year. The extended impact of that will see a fall in Australian government bond yields next year, whcih will exceed the yield drops expected for US Treasuries. Combined it will keep downward pressure on AUD for the coming months.’

Ending the year as it began?

Given its extended period of outperformance in recent months, it's easy to forget that AUD began the year as one of the worst-performing majors, hammered by headwinds including a jump in ten-year yields on US bonds, which had risen to their highest levels since February of 2020. The rise in demand for government debt sent most of the world's biggest stock markets into losses.

Given AUD's 'high beta' status and its historically close connection to shifts in broader risk sentiment, the Australian dollar was on the up when markets were trending higher. It began to fall again when January’s equities sell-off got underway.

The Australian dollar to US dollar exchange rate fell by a full third of a percentage point to trade at 0.7185, while the pound to Australian dollar exchange rate lifted by one-quarter of one per cent to reach 1.8969

Analysts at Bloomberg posted a blog reflecting what many analysts believed at the time: 'markets headed lower as bond yields began to rise. The thing to watch for will be whether or not US stock traders decide that the equities sell-off should continue or ease off.'

Had American government bond yields continued to rise higher, it would have had the knock-on effect of raising the cost of financing dollar-denominated around the globe.

Australia's top foreign exchange earner was and remains its range of commodities used in manufacturing like iron ore. When global growth slows down, demand for Aussie experts will too. When bond yields are on an upward trajectory, AUD is more likely to be under pressure.

One factor that has pushed bond yields higher is market hopes for a combination of interest rate hikes and QE tapering by the US Fed. America is still experiencing inflation levels not seen since the early 80s. That's putting pressure on Fed policymakers to raise interest rates and tighten up the easy money that's been available to markets since the pandemic.

'We're till watching for sudden lurches and retracements as markets price-in the dynamics of inflation and directional signals for Fed policy,’ said Bloomberg.

Rabobank Remains an AUD bull

Despite the dour prognosis, FX analysts at Rabobank are maintaining a sunnier disposition where AUD’s prospects are concerned. In a research note they said Australia’s labour market is strong, and rising wages will likely outstrip RBA forecasts. While that could contribute to inflation, it could also create upside for AUD.

Rabobank’s call comes after a challenging 2021 for Aussie, which saw it descend from a high of 0.79 against the greenback to a December 2021 low of 0.6994. The pound to Australian dollar rate rose steadily through the year, starting at 1.7414 in January to a peak of 1.9149 in November.

According to Rabobank, one of the significant influencers behind the AUD/USD's relative softness last year was the RBA's ongoing dovish policy stance. 'Going into the end of 2022, there is potential for this to improve.'

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