AUD Is 10% to 15% Too High For RBA’s Comfort: HSBC

Following the Reserve Bank of Australia Governor’s indication last December that he would prefer AUD to be US75 cents, and the subsequent fall in commodity prices, HSBC suggests the AUD is probably still 10% to 15% above the RBA’s comfort level.

Paul Bloxham, Chief Economist at HSBC in the May 19, 2015 research report titled: “AUD is still too high for the RBA” notes Australia’s central bank is quietly fighting a currency war.

AUD to drop further despite its substantial fall recently

According to the HSBC analyst, in the heady days of the commodity prices boom back in 2011, one Aussie dollar was buying a whopping $1.10 US. However, since then, the AUD declined by almost 30%, to US80 cents today. Despite this steep decline, recently the RBA Governor indicated he would prefer the AUD to be US75 cents. Moreover, since then, commodity prices, which are seen as a key driver of the currency, have fallen further.

ValueWalk recently reported that despite Australia being a major developed international market in its own right, its performance has clearly been different than other DMs. One big reason is the fall in Australia’s currency against the U.S. dollar. Another factor most certainly tied into both Australia’s equity market and currency performance has been the lackluster performance of commodities, since the country is a major global commodity supplier.

Making reference to RBA’s recent statement that ‘further depreciation seems both likely and necessary’ for Australia’s economic growth to return to a balanced path, Paul Bloxham of HSBC anticipates US70 cents may be close to the right mark today, and hence he believes we are probably still 10 to 15% above the RBA’s comfort level.

Chart indicates US70 cents

According to the HSBC analyst, if AUD doesn’t fall despite the central bank “talking” about the fact that the currency is over-valued, the RBA may choose to cut its cash rate further, reducing the yield on many Australian assets, making it less attractive to hold these assets.

Taking a closer look at RBA’s own model of the currency, the analyst notes in the most recently published March 6, 2015 report, the model has the trade-weighted exchange rate on the left hand side of the equation and two key variables on the right hand side: the terms of trade and the interest rate differential. According to the analyst, the leading role is played by the terms of trade (being the ratio of export prices to import prices) with the bulk of the medium term variation in the currency explained by changes in commodity prices.

The following chart depicts a simplified version of the RBA’s model that examines the USD value of Australia’s commodity exports and the USD/AUD exchange rate.

Australia's commodity prices and the AUD

Bloxham points out that the chart (above) provides a broad sense of the RBA’s view of fair value of the currency and fits with the RBA’s own commentary. For instance, back in December 2013, the RBA Governor told the local press he thought the AUD ought to be around US85 cents, in line with the red line in the chart. Interestingly, by December 2014, commodity prices had fallen further and the Governor was indicating the AUD ought to be closer to US75 cents.

Moreover, six months later, the chart suggests that the Governor may now think it ought to be closer to US70 cents. Hence, the HSBC analysts emphasizes that at its current level of US80 cents, the AUD is probably 10 to 15% too high for the RBA’s comfort.

The HSBC analyst also points out that in much of the modeling, a 10% fall in the currency boosts growth by around 0.2ppts, which is roughly the same as a 25-50bp move in the cash rate. Moreover, the analyst believes the RBA will keep its cash rate on hold in coming quarters, though with the AUD remaining noticeably above the RBA’s comfort level, there is a clear downside risk to this view.