The Australian dollar (AUD) has held up better than expected, a function of its still-strong economic performance, high commodity prices and a broad rise in risk appetite. However, we still think it is set to lose some of its shine against the USD, even though it may well continue to out-perform others in the G10. The fundamental backdrop is still healthy, despite signs of slowing, and the inflation profile - while worryingly high - could lead to another interest rate hike, which will still lend some support to the currency.
Economies where the growth profile is slowing rapidly and inflation is increasing are not particularly attractive but the AUD is not in such a precarious position in terms of the economic data. This means a further interest rate hike to calm inflation may not come at the expense of completely stalling growth, as we fear may be the case in some other G10 economies.
The latest raft of fundamental data has held up very well. GDP growth in the first quarter came in at a respectable 0.6% quarter-on-quarter which implied an annual growth rate of 3.6%. While growth has slowed slightly compared to 2007, it remains considerably higher than the other G10 countries which are crawling along. Given the mix of the data emerging for the second quarter, it is certainly not inconceivable to see strength continuing through the year. The latest building approvals were much higher than expected, rising 7.8% month-on-month, while the strength in commodity prices has fed through to improve exports and bring the trade deficit down to under AUD1bn for the first time since early 2007.
There is even a possibility that with commodity prices continuing to surge higher, the trade balance could even move into positive territory at some stage this year. This would all be beneficial to Australia's growth and increases the chances that the Reserve Bank of Australia (RBA), will raise rates again to cope with this target.
Although growth was strong, some measures have started to drag slightly, including retail sales and some confidence measures. Notable weakness was seen in the most recent employment data which showed a contraction of 19,700 jobs and a slight tick up to 4.3% in the unemployment rate.
However it is worth bearing in mind that unemployment is still historically low, and the RBA will need to see further evidence of cooling in the labour market to be convinced of a significant turnaround. The overall picture shown by the available mix of data is proving strong enough that the RBA will probably continue to be concerned by a high and rising growth-inflation mix. This may mean an interest rates rise with growth and inflation as compared to other G10 countries where interest rates may be rising on falling growth and high inflation. On a relative basis, this is AUD positive.
The RBA kept its balanced approach in its statement following its decision to keep interest rates unchanged at 7.25% on June 3. The upside risks remained the same: high inflation (4.2% year-on-year in the first quarter - well above the RBA's target band upper limit of 3%), high and rising commodity prices and their positive impact on the terms of trade and worries about inflation rising. The RBA also mentioned the possible downside risks of the slowing economy in the form of "substantial tightening in financial conditions" which it noted was "helping to produce a moderation in demand". Therefore it kept its tone that should the activity picture not slow sufficiently, then the interest rate outlook would need to be reviewed.
However, the statement was made the day before the GDP data was released, and the strength of this number suggests the risks for interest rates are biased towards a hike. While certain areas of activity have started to moderate, there will need to be a much wider slowing in activity indicators to prevent another hike.
So what does this mean for the AUD? After the decision to leave interest rates unchanged, the market still believed the RBA was far from finished raising rates and this led further support to the AUD keeping it close to its recent 26-year highs.
This suggests the market still believes in the AUD commodity/growth story. However, analysts believe that the fundamentals will soon start to change. Once the economy shows clear signs of slowing, the AUD will eventually suffer. However, we have not reached this stage yet, and analysts think that in the short term it will continue to be supported against most G10 currencies by high commodity prices and its higher interest rate outlook.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.