Reserve Bank Of Australia Holds Rates, Leaving Currency To Drift Lower

Includes: FXA
by: Duru

In its latest statement on monetary policy, the Reserve Bank of Australia (RBA) said nothing new. The RBA left rates unchanged at 3% while at the same time making it clear that the inflation outlook leaves it with plenty of "scope to ease policy further" if needed. The economic outlook remains anemic but downside risks are apparently diminishing. It was another not great, but not too bad statement.

Going into Monday's trading, the Australian dollar (NYSE:FXA) swiftly hit levels last seen in July 2012. The move seemed to indicate the market's fear that the odds of another rate cut were higher than consensus expectations. However, by the close of U.S. trading, the Australian dollar had recovered most of its overnight losses. The RBA statement caused a further advance that at the time of writing is holding steady.

The Australian dollar breaks down briefly from presumed support at the 2010 and 2011 closes

The short-term trend on the Australian dollar remains decidedly downward. In January, the currency failed to break the downtrend in place since the 2011 highs (the tail end of that line is show in the graph above). Hitting a 7-month low seems to affirm that the overall bias remains downward. Thus, the latest statement from the RBA indicates the central bank is willing to let the currency drift lower on its own for now.

Last month, the RBA described in more detail than usual the link between monetary policy and the exchange rate, clarifying that the exchange rate is not targeted but excessively high levels can create economic conditions conducive toward lowering rates. In the latest statement, the RBA once again showed no alarm regarding the high rate but reminded markets that the rate is too high. Typically, the RBA expresses this relative to terms of trade that have passed their peak. This time, the RBA added a little twist referring explicitly to export prices and referencing low credit demand as a bonus:

…the exchange rate remains higher than might have been expected, given the observed decline in export prices, and the demand for credit is low, as some households and firms continue to seek lower debt levels.

I believe this extra emphasis is the RBA's signal to the markets that it believes economic conditions are quite vulnerable to prolonged strength in the Australian dollar.

Interestingly enough, last week, the RBA published its commodity price index for February showing a fourth straight month of gains. Commodity prices remain strong, and the chart below almost makes it seem like a fresh rally is underway.

RBA Commodity Price Index (February, 2013)

Source: Reserve Bank of Australia

If current forecasts for lower iron prices hold true, this index should at least stall out in the coming months. As the second half of the year approaches, I will be watching closely. If somehow commodities remain strong, the RBA will at least need to back off from its bias to stand ready to lower rates.

(The latest forecasts for lower iron ore prices come from Deutsche Bank, Rio Tinto, and Goldman Sachs. They all cite common themes: the cooling of over-speculation, the end of stockpiling, increased supply coming - especially in China, and slower growth in steel production).

Be careful out there!

Disclosure: I 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 short AUD/USD