The horrific developments in Ukraine have turbo-charged commodity prices, a key driver of the AUD.
We have made significant changes to our commodity price forecasts. These forecasts are set out the Westpac Market Outlook which has been released today. Our working assumption is that almost all the surge in the oil price is behind us. Russia’s crude exports have been largely eliminated from global supply as official sanctions, voluntary sanctions and shipping disruptions have already severely curtailed supply.
From this point we expect there will be some slow responses on the supply side, from other producers, while some demand will be dented by high prices. We are assuming an oil price of US$100/bbl through to end 2022. Other key commodity prices for Australia – coal and base metals – are also expected to hold at extremely high levels through to year’s end.
Given our new commodity price forecasts, fair value AUD models that do not include a subjective proxy for risk are screaming that it is heavily undervalued. But our expectation of ongoing elevated commodity prices is also coinciding with a period in which high risk aversion is dominating markets.
The Australian dollar is a ‘risk on’ currency so we have been quite cautious with near term upward revisions to our currency forecasts. Our June target has been lifted from USD0.70 to USD0.73, bearing in mind that by this time we also expect the FOMC to have raised the federal funds rate by 75bps, in three quick tranches.
One potential factor that may offset Australia’s traditional position in markets as a ‘risk on’ asset is its remoteness from Ukraine and Russia. But nervous investors might also view our geographic position as vulnerable insofar as the current conflict plays into China’s stated plans for Taiwan.
As risk concerns gradually ease through the second half of 2022, and the RBA begins its own tightening cycle by August, the boost to the AUD from the elevated commodity prices can be more sustained. Accordingly we have lifted our AUD forecast by end 2022 from USD0.73 to USD0.76 – above its long term average.
Risk fears will be further contained through 2023 as markets accept that inflation can slow and central banks can navigate soft landings for their economies. A more ‘risk on’ sentiment in markets from late 2022 will further embolden the AUD and, with relatively high (although easing) commodity prices through 2023 the Australian dollar is expected to move back to USD0.80.
A genuine risk to this strong AUD scenario in 2023 will be that markets are likely to need to reassess the peak in the RBA’s tightening cycle. We expect a peak of 1.75% by the first quarter of 2024 whereas markets are currently priced for a peak of around 2.4%. However we expect that the risk on/high commodity price profile will more than compensate for the interest rate disappointment.
The persistence of risk aversion in 2022 will favour safehaven investments like US Treasuries (USTs) and gold. We acknowledge that inflation pressures and persistent rate hikes from the FOMC will still mean higher US bond rates. The inflation component of USTs has already lifted to around 2.75% (implying unrealistically negative real yields). We also expect five FOMC rate hikes over 2022. However we have slightly lowered our 10yr rate profile by end 2022, from 2.4% to 2.3%, to account for this increased safe-haven demand.
Risk aversion does not favour Australian Government Securities (AGSs) in global markets, given Australia’s ‘high risk’ label. Current spreads between AGSs and USTs are likely to remain wide but, nevertheless, contract to around 20bps from the current recent historical extremes of 40bps.
We have lifted our forecast peak in Australia’s headline inflation in 2022 from 4.2% to 5.0%, capturing both the direct and indirect effects of the higher oil price profile.
That has only slightly impacted our forecast for underlying inflation with the peak increasing from 3.5% to 3.7%. Consequently our profile for the RBA – first hike in August to be followed by a second in October – remains intact. Higher headline inflation has raised some genuine concerns for the RBA around inflation expectations (available measures are benign but have tended to be quite erratic and unreliable). However, the spectre of significant risk and lower global growth, particularly in Europe, should see the RBA remaining patient over the next few months.
Our view is that the RBA will respond to the expected Q1 CPI prints on April 27 – annual headline at 4.4% and underlying at 3.1% – with a decision that the ‘patient’ rhetoric needs to moderated through June/July, with a clear tightening bias emerging.
The Q2 CPI prints on July 27 – annual headline at 5.0% and underlying at 3.6% – are expected to be enough to signal ‘lift off’ at the August 2 Board meeting.
