The sudden spike in the market's assigned odds of a rate cut in the February Reserve Bank of Australia ((RBA)) meeting summarizes the current prospect for continued weakness for a weaker Australian dollar (NYSEARCA:FXA) in the coming weeks.
A sudden and sharp spike in the market's odds for a February rate cut by the RBA
Source: ASX RBA Rate Indicator
The salient driver of this increase seems to be a weaker than "expected" report on GDP growth. This was a week full of important economic data and releases, so I will start from the beginning.
On Sunday night, the RBA released its November update for its commodity index. I am sure no one was surprised to see the continuation of a now 3 1/2 year long reversal in commodity prices. In SDR terms (independent of the Australian dollar's exchange rate), the commodity index has plunged 18.6% year-over-year led by the drops in iron ore and oil.
The plunge continues nearly unabated
Source: The Reserve Bank of Australia Index of Commodity Prices (November 2014 update)
On the evening of December 1st (morning of December 2nd in Australia), the RBA delivered its latest decision on monetary policy. The RBA delivered absolutely no surprises and stuck to a well-worn script in leaving rates alone and reminding the market that "…monetary policy is appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target. On present indications, the most prudent course is likely to be a period of stability in interest rates." Despite the 4-year low in the Australian dollar versus the U.S. dollar, the RBA of course still thinks "…the Australian dollar remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices in recent months. A lower exchange rate is likely to be needed to achieve balanced growth in the economy."
The Australian dollar's downtrend versus the U.S. dollar continues
The next day came a lackluster report on GDP. GDP growth was 2.7% year-over-year and 0.3% quarter-over-quarter, under "expectations" for 3.1% (according to dailyfx.com). Of course, there are many developed countries that would be quite happy with 2.7% GDP growth but Australia has high expectations, particularly with unemployment at post-crisis highs.
The GDP report included a mix of good and bad news. According to the Australian Bureau of Statistics (NYSE:ABS), exports led the way in GDP growth with a 0.8 percentage point contribution quarter-over-quarter. Household expenditures contributed 0.3 percentage points. The big lead weight on the economy was total gross fixed capital formation with a -0.7 percentage point contribution. This was disappointing but not a surprise given the large and on-going contraction in investment in the mining sector (per the RBA: "Resources sector investment spending is starting to decline significantly, while some other areas of private demand are seeing expansion, at varying rates.") Compounding the bad news was a drop of 3.5% in the terms of trade. The following chart shows the overall impact on national income: it has ground down to a halt again. Notice the significant overall weakness ever since commodities peaked in 2011.
Net national income growth has ground to a halt again
Source: The Australian Bureau of Statistics (ABS)
This bleak turn in national income did not stop spending in November. After a strong September period led by sales of Apple's new iPhone 6, Australian retail sales increased 0.4% in October. According to the Australian Bureau of Statistics (ABS), the only major category to contract in the month was cafes, restaurants and takeaway food services (-2.1 %).
Moreover, the trade balance continued its decline into deficit territory. According to the ABS, the trade balance in October was about -$1.3B.
Despite the improvement in November, Australia's trade balance is still trending sharply downward
Source: The Australia Bureau of Statistics
So, on balance, it makes sense for the RBA to remain on hold, but the market is clearly starting to itch for action. Without a significantly positive change in the economic data, I am assuming the Australian dollar will reflect this anticipation with a continuation of its general weakening. With an on-going downtrend against the U.S. dollar and rising expectations for a rate cut, a trend-following strategy appears worth the risks again (as opposed to a more conservative "wait to fade" strategy).
The way forward is not entirely clear however. For example, Australia's property markets are strong and getting hotter. The Organization for Economic Co-operation and Development (OECD) recommends that the RBA start considering a tightening of monetary policy next year:
"Short of negative surprises, withdrawal of monetary stimulus should start in the second quarter of 2015. The booming housing market and mortgage lending will require continued close attention by the authorities. There is room for both fiscal and monetary policy to provide support in the event of unexpected negative economic shocks."
This tightening bias runs in direct contrast to recent calls from Deutsche Bank, Goldman Sachs, and now Westpac's chief economist for the RBA to begin cutting rates next year. These are all recent shifts in thinking that are aligned with (or perhaps even helping to drive) the surge in market expectations for a February rate cut.
The regional economies are out of balance with Sydney taking over for the mining sectors and doing quite well. Sydney's fastest growth rate in 14 years was responsible for 38% of Australia's economic growth in the past financial year as reported by the Sydney Morning Herald. The next biggest contribution was 29% from Western Australia, which is heavily dependent on commodities. A rate cut will certainly drive the Sydney property market to over-heating, at least without additional "macroprudential" measures.
Given these dynamics, I think the RBA is more inclined to continue to wait things out and only cut rates if it comes to conclude that it will generate a sustained weakness in the currency. It will now take two months, a relative eternity in forex markets, to find out the answer.
Be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am net short the Australian dollar