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Australian Dollar Outlook

Kathy Lien, Director of Currency Research, GFT

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It has been a choppy year for the Australian dollar, which traded lower against some currencies and higher against others. Normally, the AUD/USD is a very trending currency pair, even in times of heightened uncertainty. However, over this past year, the price action has been extremely schizophrenic with the Aussie rising and falling hundreds of pips on a weekly basis. This volatility stems from the problems in Europe and the impact that various headlines have had on currencies. Unfortunately, as the year draws to a close with no clear solution to Europe’s debt troubles, the Australian dollar could remain vulnerable to global uncertainties. Australia’s dependence on foreign demand makes it particularly vulnerable to the performance of other countries. With growth slowing in China at a time when the markets are so volatile, it may be difficult for the AUD/USD to hold onto any gains in the beginning of the year. Of course, this can change if Europe comes up with a credible solution to their debt crisis, but as things currently stand, it may be some time before that happens.

Australian Economy Will Grow but at Slower Pace

Growth in Australia in the coming year will be stronger than many other developed countries around the world. Even after slashing their GDP forecasts in late November, the Reserve Bank of Australia is still looking for the economy to expand by 3.25 % in the current fiscal year ending June 2012. After that, they predict the same pace of growth for 2012 to 2013. Job growth is expected to increase by 1% to June with the terms of trade rising 1.75%. The greatest support for the Australian economy is their high terms of trade, which has been boosted by China’s insatiable demand for iron ore and coal, the country’s two most important exports. Even as iron ore prices declined, the volume of demand more than made up for the difference. Looking beyond the commodity sector, however, there are pockets of weakness in the economy. Job growth in general has slowed while consumer spending has been anemic. The latest manufacturing and service sector data also shows continued contraction in the two main areas of the economy. But slower growth in Australia comes at a time when growth in other countries is moderating as well. If the outlook for the Australian dollar was determined exclusively by relative economic performance, Australia’s stronger GDP growth should support the currency. Unfortunately, Australia does not exist in a vacuum and cannot separate itself from the rest of the world. For this reason, the outlook for the AUD/USD hinges upon the global economy.

Will China Continue to Underwrite Australian Growth

Throughout the global financial crisis, China has shielded the Australian economy from a deeper slowdown and prevented the country from falling into recession. The big question in 2012 will be whether or not China continues to underwrite Australian growth; the answer is yes, but to a lesser degree. There are many signs that the Chinese economy is slowing and in some ways, the Chinese government is happy to see this happening because it will help deflate the housing market and reduce inflationary pressures. The challenge for Chinese policymakers is whether they will be able to effectively engineer a soft versus a hard landing. In late November, the Chinese government cut their reserve-ratio requirement to increase liquidity and support the economy. Steps such as these should help to prevent a hard landing. Unlike other countries, the Chinese government also has plenty of room to ease monetary policy and provide fiscal support − even if the real estate bubble bursts, which would materially affect consumer sentiment and sap domestic demand. A soft landing in China would help support the Australian economy and limit the downside for the AUD/USD.

Monetary and Fiscal Policy

After leaving interest rates on hold for most of the year, the Reserve bank cut rates by 25bp in November. At the time, they cited moderating employment growth and increasing uncertainty in Europe as the main reasons why they felt easier monetary policy was needed. The move appeared to be nothing more than an insurance cut, but it shows that the central bank is willing to ease if they feel that it is necessary; with interest rates at 4.50%, they have plenty of flexibility to do so. Therefore, if the Eurozone economy falls into a recession and the markets become extremely volatile in the first half of 2012, there is scope for an RBA rate cut, but such a move could hurt the Aussie as its loses some of its interest rate advantage. Monetary policy is not the only area that the Australian government has flexibility. Fiscal finances are also very healthy with the budget deficit expected to be only 1.4% next year. If investors start investing based upon the health of a country’s balance sheet, the Australian dollar would come out a winner.

Be Wary of Deleveraging Risk

Unfortunately, balance sheets do not matter when investors are nervous and flock to the safety of low-yielding currencies. The greatest risk for the Australian dollar in the coming year is not the performance of the Australian economy, but rather the continued uncertainty in Europe. In 2011, we saw how much damage risk aversion can have on the Australian dollar, so if the problems in Europe intensify and rating agencies start to cut ratings left and right, the Australian dollar could fall sharply, even if the government is doing a fantastic job of managing its balance sheet and its local economy. In the U.S. dollar portion of our outlook, we talked about how next year may not be a good year for carry trades because the global economy is expected to slow, causing central banks to ease monetary policy. For carry trades to perform well, volatility needs to be low and central banks need to be tightening, not loosening, monetary policy. As a carry trade currency, this does not bode well for the Australian dollar’s outlook.