Currency Outlook

The Australian dollar (AUD) has trended consistently higher against the US dollar since mid-October, yet much of this can be explained away by US dollar weakness. In fact, on a trade-weighted basis, since the beginning of November, the AUD has moved broadly sideways.

With the Royal Bank of Australia (RBA) doing little to engender optimism in the market, or dampen it for that matter, it remains to be seen whether this stability will dissipate anytime soon.

An issue that weighs in favour of the RBA's recent cautious approach is the drought. The economic data that has been released has provided an increasingly mixed backdrop. GDP growth in quarter three of 2006 of only 0.3 per cent failed to match market expectations, leaving annual output growth at a decidedly modest 2.2 per cent.

The trade deficit, which had until recently been on the verge of heading into surplus territory for the first time since early 2002, has widened unexpectedly in each of the past two months.

Crucially, business investment, for so long the pillar of Australian's impressive economic growth performance, is now proving a heavy burden. Nevertheless, it has not been a case of irreversible doom and gloom.

The labour market continues to brush off suggestions that its recent record breaking performance is unsustainable. The unemployment rate unexpectedly remained steady at the all-time low of 4.6 per cent in November.

Domestic spending is holding up resiliently - retail sales were up 0.8 per cent in October, the 13th month in succession without a contraction of sales. This comes despite the fact that base interest rates now stand at their highest levels in a decade.

The outlook is by no means damning for the AUD. With such conflicting signals coming from the macro data, the Aussies' recent intransigence becomes easier to comprehend. Indeed, this neutrality is reflected in the cautious tone of the RBA.

In recent comments, Governor Glenn Stevens was certainly not getting carried away in his assessment of the prospects for 2007. While hinting at upside risks to previous growth projections, it was not a glowing report.

"Moderate expansion" in consumption is expected to be augmented by stronger growth in exports, while business investment is projected to expand at a much slower rate. Any market participants looking for signals of further hikes would have been disappointed.

A related issue that weighs in favour of the RBA taking a cautious approach is the ongoing drought. The reason being that it is hard to fully determine how long the drought will last and how severe the implications will be, even though some assumptions have already been made.

As acknowledged by its most recent statement, the RBA is aware of the drought, but Governor Stevens makes the point that although it will increase prices, it may not affect inflation in the medium term.

So in the eyes of the RBA the drought hitting Eastern and Southern Australia may have some inflationary impact but it should not last long, hence there is no need for concern at present. The risk, however, is that the drought may turn out worse than the RBA is currently thinking.

The government is shaving nearly 0.50 per cent off GDP growth projections next year because of the drought, thereby reducing real incomes and bearing down on demand.

With weakness in business investment growth already evident, the resurgence in housing construction likely to be delayed by higher mortgage rates, and consumers continuing to moderate spending, the outlook for 2007 now depends completely on the long awaited strengthening of export volumes.

Rural production is not the main engine of the economy, since it accounts for just under three per cent of total GDP. On a trend basis rural exports have been lending less support to the domestic economy for some time while non-rural exports, predominantly mining activities, have had the exact opposite effect.

This makes sense given robust demand for metals, in particular by Asian countries. The drought alone has negative growth implications but it is not expected to be disastrous for the broad economy. However, the combination of a severe drought weakening domestic growth and expectations of a weaker external environment should see the market at least rethink whether the RBA will continue raising interest rates.

Given these trends, it is most probable that the RBA will not have to make a serious decision on interest rates until the middle of the year. The RBA's overall message is that it is in a wait-and-see mode, whether including the impact from the drought or leaving it aside.

Should the drought worsen, the RBA and the market would likely reassess their views on Australian growth and inflation (i.e., they will become more pessimistic). This means that the RBA will start factoring in weaker growth and higher inflation than what it is currently thinking.

Inflation fighting via higher interest rates is often deemed currency supportive if growth is also robust. However, if higher inflationary pressures coincide with a weaker growth outlook this will probably result in a weaker Australian currency.

This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.