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Why the AUD is about to give the RBA a major headache

Chris Weston
Head of Research
28 Aug 2020
We can look at the Australian economy and see economics are obviously not great, but that won’t surprise given the COVID19 shutdowns.

We know the RBA have 3-year bond yields capped at 25bp and should the market start shorting bonds with greater conviction then the RBA’s balance sheet will only get ever larger. We can only expect more policy accommodation from the RBA and certainly not less, because like so many other central banks they are a price taker and they simply have to keep pace with measures from the Fed, or they run the risk of policy divergence, which just means a stronger currency.

The AUD is not really a reflection of Aussie economics anyhow and we see it as a vehicle to express a view on reflation and improving semantics more broadly. I also feel that the AUD is one of the clearest beneficiaries of newly evolved Fed policy, with the Fed moving to Average inflation Targeting or ‘AIT’. The way I see it, if the Fed is truly committed to proactively driving inflation not just to the 2% target, but above for a sustained period, then they need to drive up inflation expectations. If they can influence inflation expectations they can change consumer behaviour and drive animal spirits, which then manifests into underlying inflation.

They would strive for a weaker USD, as this is reflationary and lifts inflation expectations and asset values. Higher inflation expectations lead to lower real yields, which again play full circle into inflation.

The real question though is how the Fed goes about creating inflation above 2% - what methods and actions will they employ and how credible will they be? These will no doubt be revealed to the market in the near-term and will certainly be explored in upcoming speeches from the Fed ranks, and dominate the discussion in the 18 September FOMC meeting. But the fact is though, the Fed is actively seeking to create inflation and that has huge implications for markets, and the AUD could be a major beneficiary.

We're going to see the Fed continue to be creative with policy and perhaps even turn up the dial if they truly want the market to view their new policy directive as credible. Commodities should in turn benefit, at a time when economic growth is on the mend anyhow. As mentioned, one of the best vehicles for trading improved semantics and commodity appreciation is the AUD and we can already see the market warming to this view, with the AUD the strongest major currency since Jay Powell announced a move to AIT. We have a bullish breakout in AUDUSD, and should we see a weekly close above 0.7274 then it opens the pair to start trending towards 0.7500. Consider price has also broken above the 200-week MA and a weekly close above 0.7253 could be quite powerful.

While there are many questions about how the Fed actually creates inflation. However, if they are truly committed to the cause and the market buys it, then the AUD goes higher and the RBA will have to tolerate AUD strength as there is little they can do against a truly committed Fed, but the level of concern about rising exchange rate will start to dial-up – potentially in next week’s RBA meeting.

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