The Australian dollar’s top forecaster says the relatively high interest rates normally seen as a strength of the currency could turn out to be its weakness in coming months.

The yield premium that Australian debt offers over developed market peers has helped to fuel investor appetite for the local dollar, but that might change with the Reserve Bank of Australia having more room than its counterparts to lower its benchmark, according to Unicredit SpA. The “overvalued” Aussie will underperform other commodity currencies such as the Canadian dollar and Norway’s krone, London-based Vasileios Gkionakis head of global foreign-exchange strategy at the firm said.

“The margin for conventional monetary policy easing is much higher in Australia compared to Canada and Norway,” Gkionakis said in a telephone interview last week. “So from that respect, I can easily see the markets pricing more rate cuts by the RBA compared to Bank of Canada and the Norges Bank.”

With its benchmark interest rate at 1.75 percent, the RBA can bring to bear the most conventional monetary ammunition after its counterpart in New Zealand among developed-market central banks. The prospect of using that in the event of global uncertainty will cap gains for the currency, according to Gkionakis. He expects the Aussie to be little changed, oscillating around the 75 U.S. cents mark for the rest of the year.

That is still more bullish than the median forecast of 71 cents by the end of the year. The Aussie bought 75.51 cents at 5 p.m. in Sydney Monday. It has risen 3.6 percent in 2016, on course for its first annual gain in four years. The currency climbed to a 10-month high of 78.35 April 21 before the RBA unexpectedly cut rates in May.

The central bank will probably cut its benchmark cash rate, from the current record low of 1.75 percent, once in 2016 with employment data outweighing concerns over China growth and inflation, he said. Swaps traders are pricing in a 78 percent chance of RBA reductions by the end of the year.

Five-year yields were as much as 69 basis points higher in Australia than they were in the U.S. last week, providing the biggest premium since May. Futures signal 21 percent odds the Federal Reserve will raise interest rates this year, from 76 percent at the start of June.

“We are constructive on risk in general,” Gkionakis said. “With the Fed probably putting off rate increases, or at least slowing the pace of rate increase, the hunt for yield is going to remain in place just as long as Brexit does not balloon into an event that causes global repercussions.”

Unicredit prefers the Canadian dollar and krone over the Aussie because the two are “undervalued” according to criteria including terms of trade and real rate differentials. It still favors the yen, seeing further appreciation possible while Gkionakis doesn’t expect the Bank of Japan to intervene unilaterally to weaken it.

Gkionakis expects the Aussie to be supported at recent lows at around 72 U.S. cents, though a break below that could “accelerate falls.” At the upper end, he sees RBA jawboning at around 2016 high of 78 cents.

Inflation Rate

The transition away from China-led growth is already underway in the economy and inflation, while remaining below target, should start to push higher due to the “base effect,” he said. The central bank’s last rate reduction in May came after official data showed core consumer-price inflation slowed to 1.7 percent, the weakest on record, and forecasters are predicting the next quarterly release on July 27 will enable another policy shift.

Australia’s unemployment rate currently stands at 5.7 percent and, although payrolls grew by a better-than-expected 17,900 positions in May, that gain was entirely due to growth in part-time jobs. June figures are scheduled to be released on July 14.

“The wild card for me is domestic employment dynamics,” Gkionakis said. “If the unemployment rate picks up, you’ll see the market pricing in more rate cuts, which will have a negative effect on exchange rates.”

Source:
courtesy of BLOOMBERG

by Narayanan Somasundaram

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