The Australian Dollar Defies The RBA's Easing Bias

Summary

The RBA, Australia's central bank, cut rates to another record low.

After a brief dip in the Australian dollar, traders rushed in to buy the currency, in a move that keeps the currency rallying alongside iron ore.

An economist's lament about a slow RBA demonstrates a growing conundrum given a macro environment featuring aggressive accommodation in most major economies.

My bias leans on a belated weakening in the Australian dollar in coming weeks.

The Reserve Bank of Australia (NYSE:RBA) kicked off central bank action for August with a rate cut to a fresh record low of 1.50%. Financial markets were anticipating a cut, with odds bouncing between 55% and 70% for most of the past month. So while it might be no surprise that the Australian dollar (NYSEARCA:FXA) only experienced a small and temporary drop in response to the rate cut, it SHOULD be a surprise that the RBA finds itself with an even stronger Australian dollar than it had at the end of July's meeting. That meeting featured no rate cut and no talk of an imminent rate cut. In fact, AUD/USD is reaching for July's high in the middle of a volatile uptrend. This uptrend is struggling to resume the momentum that marked the recovery from the January low.

This 5-minute chart shows how the Australian dollar took the briefest of dives in the wake of the RBA's rate cut. The subsequent rally was very strong and only peaked shortly after U.S. trading began.

The Australian dollar has shown persistence and resilience in 2016 against the U.S. dollar.

Source: FreeStockCharts.com

The Australian dollar has rallied, albeit in very choppy form, against the U.S. dollar (NYSEARCA:UUP) since the May lows. Since that time, the U.S. dollar index has itself rallied - albeit with a major stumble in June - so we know the Australian dollar is doing relatively well against a basket of currencies. The dollar's big post-Fed, post-GDP stumble has made the RBA's work even more difficult.

The RBA's work just got harder, with the U.S. dollar taking a major stumble since the Fed and then U.S. GDP.

Source: FreeStockCharts.com

The market's bullish reaction to the RBA rate cut suggests the cut itself was practically immaterial to trading decisions, except to create a contrary response (note that speculators flipped bullish on the Australian dollar over the previous three weeks). I do not think it is quite accurate to say that the cut was already "priced in." For example, shortly after the July RBA meeting, the Australian dollar traded higher and never traded lower. I believe a better explanation rests on a muddled monetary policy that consistently leaves the Australian dollar exposed to the market's default yield-seeking behavior.

In familiar form, the RBA did not provide specific guidance about its thinking for future rate cuts. It left the market to speculate that the central bank could be at the end of this latest rate-cutting cycle. Indeed, the RBA's statement on monetary policy expressed plenty of its typical optimism about the Australian economy. For example:

"In Australia, recent data suggest that overall growth is continuing at a moderate pace, despite a very large decline in business investment. Other areas of domestic demand, as well as exports, have been expanding at a pace at or above trend. Labour market indicators continue to be somewhat mixed, but are consistent with a modest pace of expansion in employment in the near term."

Even when it discussed slowing activity in the housing market, the central bank cheerily offered up this development as a reason to disconnect record low interest rates from the potential for a housing bubble:

"The most recent information suggests that dwelling prices have been rising only moderately over the course of this year, with considerable supply of apartments scheduled to come on stream over the next couple of years, particularly in the eastern capital cities. Growth in lending for housing purposes has slowed a little this year. All this suggests that the likelihood of lower interest rates exacerbating risks in the housing market has diminished."

If not for this "excuse" paving the way for a rate cut, one could read the RBA's statement out of context and wonder why the RBA cut rates at all. When the RBA cut rates to 1.75% in May, it was VERY clear about its rationale in the FIRST paragraph:

"At its meeting today, the Board decided to lower the cash rate by 25 basis points to 1.75 per cent, effective 4 May 2016. This follows information showing inflationary pressures are lower than expected."

Compare May's explanation to the lonely first paragraph of the August statement:

"At its meeting today, the Board decided to lower the cash rate by 25 basis points to 1.50 per cent, effective 3 August 2016."

No wonder traders thought this latest cut was a free license to act contrary. The Australian dollar sold off swiftly after May's rate cut.

Australian economist Stephen Koukoulas, managing director of Market Economics, lamented the RBA's decision in a piece titled "Interest rate cut too little, too late by an RBA with flawed glass half full attitude." Koukoulas referenced the central bank's sometimes surprising preference for upbeat language even in the middle of a rate cut cycle. He claimed this attitude has prevented it from being as aggressive as early as it should have been with rate cuts. Koukoulas juxtaposed the RBA's reluctance with the aggressive easing in other industrialized economies:

"On Tuesday it cut official interest rates to 1.5%, but in doing so it leaves the Australian economy condemned to some of the highest interest rates in the industrialised world. The RBA has not looked all that closely for overseas guidance - this latest cut comes years after the US, the eurozone, Britain and Canada set interest rates at 0.5% or less."

Koukoulas complained that this sluggishness has produced an inexcusably high unemployment rate in Australia:

"The unemployment rate in Australia is the same as it was at the depths of the global financial crisis. This extraordinary lethargy in the labour market has occurred simply because the economy has been too weak to create enough jobs to lower it."

Yet, a key difference between Australia and the rest of the industrialized world that moved aggressively on monetary policy is that Australia never suffered a recession. The commodity boom, especially in iron ore, that exploded from the financial crisis even produced a confidently resurgent Australian economy. Despite a subsequent sharp decline in the terms of trade, there have still been varying occasions for optimism in the Australian economy. In fact, Koukoulas himself has expressed the very same predilection for optimism, even to the point of suggesting that the RBA should hike rates. For example, just this past June, I referenced Koukoulas's prediction that the RBA might start to hike rates. In April, I referenced tweets from Koukoulas calling for an end to the rate-cutting cycle given rising commodity prices and a stronger economy. He predicted the RBA would soon be talking about rate hikes.

Another good example of Koukoulas's optimism came in a May Barron's piece in which he recommended that investors bet on the Australian economy. Titled "Bet on the Aussie Buck," the Barron's article featured a very upbeat Koukoulas:

"'If you're a fund manager sitting in Tokyo, Hong Kong, Boston, or London, and you're saying, 'Where in the world am I going to put my money?' Australia looks attractive in terms of yield, policy common sense, and low levels of government debt, and you would say, 'I need to have some money in there because it's a relatively good story..."

That attractive yield is the very thing Koukoulas now laments.

In total, I think the RBA's relative tentativeness on monetary policy is perfectly understandable. Surely, the RBA sees the same conditions that cause Koukoulas to bounce frequently from strident and comprehensive optimism to monetary alarm. Depending on the snapshot, the time frame, the angle, and the context, it is very possible to see a strong Australian economy that needs no further stimulus. Only the aggressive policies around the world remind us that the RBA should consider slashing rates more and more under these conditions.

For reference, the Australian dollar is up about 3% against the U.S. dollar since that May 7th Barron's piece, although the currency declined for three more weeks before bottoming.

Oh, and those commodity prices? Well, iron ore has developed a stubborn resilience this year in the face of firming steel profits and prices. The steep run-up into the March high and the subsequent sell-off had the characteristic look of a bursting bubble. Yet, April provided a rerun of March's show with a turbo boost on the upside AND the downside. At the June low, iron ore looked "dead" for good. Instead, the red-hot commodity is rallying yet again and looks set to challenge March's high. On Monday, August 2nd, the day of the RBA's policy meeting, iron ore managed to rally 4.9%. No wonder the central bank may be reluctant to read the eulogy for the Australian economy and drive rates to zero as fast as its contemporaries have done.

Iron ore just won't quit. It is rallying sharply for the third time this year.

Source: Business Insider Australia

My 2016 trading strategy on the Australian dollar has fluctuated all year, from bearishness to hedging to opportunistic bullishness - all in an attempt to keep up with market sentiment on the currency. I am currently stubbornly anticipating a resumption in the Australian dollar's decline. I believe the RBA when it says that "an appreciating exchange rate could complicate" necessary economic adjustments in the Australian economy. As long as the rate remains relatively high, the Australian economy, inflation in particular, should underperform and push the RBA to easier policy over time. This scenario produces an ongoing policy divergence with the U.S., which fades in and out of expectations for near-term rate hikes (Fed-heads recently put on brave faces for the potential of a September rate hike).

Be careful out there!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am net short the Australian dollar.