11 maj 2022 — 11 min read
As we near the midpoint of what is already an astonishing year and given the extreme volatility of the past week, it’s time to take stock in an attempt to answer the question – where to from here for the Australian dollar?
Firstly, let’s take a look back at the month of April and the first week of May to make sense of the tumultuous conditions that have characterised this period.
There are three key themes that have been driving the financial markets’ direction during this time.
First and foremost are expectations for the Federal Reserve’s aggressive tightening cycle as the US Central Bank attempts to pull down inflation from levels not seen since 1981. The second theme - Russia’s abhorrent invasion of Ukraine, the impact on commodity prices and a seemingly unavoidable stagflation (high inflation, declining growth) shock that will be felt hardest in Europe and the UK. Third, and most recent, China’s relentless pursuit of its zero-COVID policy, locking down large parts of the world’s second largest economy, prolonging supply chain disruptions, dampening economic activity and adding to concerns of a synchronised slowdown for global growth.
It’s pretty bleak.......pessimism is at extreme levels.
One only must look at April and early May’s price action across multiple asset classes to observe just how rapidly risk sentiment has deteriorated and the increasing concerns regarding the near-term outlook.
Heading into April, markets responded positively to the Fed’s 0.25% hike, taking comfort that policymakers had a sound plan to combat persistently high inflation. In addition, despite the tragedy unfolding in Ukraine, there was a sense of optimism that a de-escalation would occur - diplomacy returning peace to the troubled region.
US equity markets staged a strong recovery from March lows, having fallen sharply from all-time record highs logged in late November (Nasdaq) and early January (S&P500 & Dow).
Heading into April with gusto, the Australian Dollar was the strongest performing currency throughout February and March. The commodity-leveraged AUD soared as Australia’s commodity export portfolio served as an almost perfect offset for the war in Ukraine, given Australia’s status as a major wheat exporter and the world’s largest exporter of LNG.
From late February the Aussie ripped higher, climbing almost 8% to log 9-month highs above 76 US cents on 05 April.
On that Tuesday, the RBA held its monetary policy meeting and whilst no change was made to policy settings, the cash rate remaining at a historically low 0.10%, the RBA importantly omitted a word from its statement of monetary policy – “patience”. By no longer using the word patience in reference to when the RBA would commence raising interest rates for the first time in over a decade, markets rightly interpreted this as a signal for upcoming rate hikes.
Fast forward to the present, the RBA commenced its tightening cycle last week, raising the cash rate by 0.25% to 0.35%.
The RBA now joins its central bank peers in a globally coordinated effort to combat surging inflation caused primarily by supply shocks resulting from Covid lockdowns and sanctions imposed on Russia.
The US Central Bank – the Federal Reserve leads all central banks in terms of the velocity of expected rate increases - also raised their cash rate last week by 0.50% rather than by the conventional 0.25% increment. Expectations are for the Fed to back this up with another 0.50% hike in June and yet another in July.
The Fed is so far behind the curve in trying to contain inflation.
As is often the case with central banks – its inflation forecasts were horribly wrong.
You likely recall the frequent use of the word “transitory” – the Fed and other central banks adamant that the cost-push inflation driven by COVID related supply disruptions would quickly moderate and reverse as the global economy returned to normal pre-pandemic conditions.
And now with the spread of Omicron throughout China, supply disruptions show no signs of easing.
So, the Fed must “front-load” rate hikes – implementing a series of 0.50% hikes to push the Fed funds rate back to what is known as the neutral rate - one in which financial conditions are neither expansionary nor contractionary.
Expectations of an ultra-aggressive Fed have spooked asset markets – equities, most commodities and risk currencies have been crunched over the past 5 weeks. Many believe that the only way the Fed can contain inflation is to push the US economy into recession, the desired soft-landing a pipedream.
The easy money and historical levels of stimulus that propelled global equities to all-time highs is no longer, central banks across the globe have put an end to the party.
The result: a huge risk deleveraging. Equities are sold off from fundamentally stretched levels also leading to large declines for risk-sensitive currencies such as the Australian, Canadian and New Zealand dollars.
So back to our important question – where to from here for the Aussie dollar?
It’s very likely that we have further to run to the downside in the short term before the clouds dissipate and rays of risk-positive sunshine bring back those warm, fuzzy feelings.
Looking at where AUDUSD may find a bottom, one level popular with technical traders is 0.6760, which represents the 50% Fibonacci level derived from the 16 March ’20 COVID low near 55 US cents and the 22 February ’21 high, just above 80 US cents.
Fibonacci retracement levels are widely used by technical traders to identify areas of support and resistance and influence trading decisions.
So, we may have a couple more cents to run below current levels (AUDUSD at 0.6950 at time of release).
At these levels, and as is often the case during times of market stress, the Aussie Dollar’s selloff has overshot the mark.
On the US Dollar side, the Dollar Index (the indexed value of the Dollar versus a basket of foreign currencies) has recently traded through 104.00 – a level that has rarely traded over the past 20 years. Some forecasters are of the opinion that a Dollar Index north of 104.00 is severely overstretched, a sustained reversal imminent.
The last time the Dollar Index traded north of 104.00 was January 2017. The next 12 months saw a retreat of over 14%. Will the same occur this time around?
Probably not to the same extent, but a US Dollar reversal during 2H 2022 is plausible for several reasons.
Firstly, the US Dollar has a habit of weakening during a Fed tightening cycle.
Yes, it sounds counter-intuitive that a currency would depreciate as the central bank raises the cash rate. However, in this day and age of forward guidance, dot plots, and Fed speak, markets are well prepared in the lead up to the commencement of a tightening cycle – you therefore see a “buy the rumour sell the fact” dynamic occur.
The US Dollar rallies in anticipation of upcoming rate hikes and balance sheet reduction (unwinding of stimulus) and then retreats once the Fed’s words progress into action.
Secondly, China’s COVID situation is likely at its nadir.
We are very familiar with the cycle of COVID variant outbreaks, government response, lockdowns and re-openings having experienced multiple waves over the past 2+ years.
We know that during lockdowns, economic activity is severely suppressed but then rapidly springs back to normal levels following the easing and removal of restrictions.
China will be no different.
In addition, abandonment of its COVID zero policy may be imminent – pressure both external and from within China is mounting.
This week, the head of the World Health Organisation commented that the policy is not sustainable given what is known of the virus. It has been a very rare occurrence for the WHO to comment on a government’s handling of the pandemic.
"We don't think that it is sustainable considering the behaviour of the virus and what we now anticipate in the future," WHO Director-General Tedros Adhanom Ghebreyesus told a media briefing.
"We have discussed this issue with Chinese experts. And we indicated that the approach will not be sustainable... I think a shift would be very important."
If China does abandon its COVID zero policy it will be one of the biggest news stories for the global economy and financial markets in 2022, leading to a significant easing of global growth concerns and a wave of positive risk sentiment.
The embattled Yuan and China-linked currencies such as the Australian Dollar would stage a strong recovery.
Even if the policy is maintained, barring any new variants and outbreaks, China’s biggest cities should come out of lockdown in the weeks ahead.
Household consumption returning to normal levels will drive demand and a step-up in growth through the second half of 2022. In addition, growth will also come from infrastructure spending and investment. Last week, Communist Party leaders acknowledged the geopolitical and economic challenges caused by COVID, calling for additional policy support.
So, while the current mood of the market is firmly China-negative, this will change as the pace of growth improves. This will benefit the Australian economy delivering a supportive boost for the Aussie Dollar.
Finally – war in Ukraine.
Russia’s intent was to seize Ukraine territories via quick, special military operations. Having failed to do so, a longer drawn-out war now appears the likely path. The impact will be felt hardest in the UK and Europe, predominantly via higher energy prices. Unless the conflict escalates into a global war involving Western forces, it’s unlikely to have a disruptive impact on the Australian economy.
A longer-term effect of the Russia-Ukraine conflict will be its impact on the US Dollar maintaining its position as the globe’s reserve currency. The decision by the US and allies to freeze Russia’s foreign reserves has unleashed an intense debate about the future of the international monetary system.
A likely outcome is that some central banks reduce the size of their respective US Dollar reserves moving to increase their gold reserves as gold is the only physical asset that is universally accepted. We may also see the emergence of innovative assets like oil and metals (like copper or aluminium) in central bank portfolios. Cryptocurrencies being highly volatile do not seem a likely option, but very well could be in the future. Recent reports suggest that Russia and China are exploring initiatives to develop a universally accepted digital currency that would replace the US Dollar as the new reserve currency.
The timeline for this re-development of the international monetary system is some way off (likely 5+ years), but when/if it does occur, it will deliver a cyclical downturn for the US Dollar.
With these three factors in mind, expectations for the path of the Australian Dollar for the remainder of 2022 – near term downside pushing AUDUSD down another couple of cents with a potential base forming in the 67 – 68 US cent region.
As markets re-adjust to the Fed’s tightening cycle, inflationary pressures peak and decline and the US Dollar inevitably pulls back from 20+ year highs, the Australian Dollar should climb back through 70 US cents.
Should China shed its COVID zero policy and/or lockdowns removed within weeks (rather than months), expect a sharp reversal – AUDUSD price action climbing back to the 72 – 75 US cent region as we head into the second half of 2022.
Headwinds to global growth will remain.
First and foremost, the question of whether the Fed’s aggressive tightening will send the US economy into recession.
With bond holdings close to US$9 trillion, the Fed’s reduction of its balance sheet is likely to cause more angst for markets rather than multiple 50 basis point hikes. Due to this and other headwinds, the Australian dollar is unlikely to push beyond the mid 70’s to challenge 80 US cents once again.
Expect volatility to remain throughout 2022 and the Aussie to range between 70 and 76 US cents during the second half.
For more information and to discuss your business’s foreign currency, payments, and hedging needs, speak to your Xe account manager or call the corporate team on +61 2 9069 3327.