| It’s been an eventful week for Australian rates and FX as the recent move up in G10 yields has been especially pronounced in Australia. In the 10-year sovereign yield space, Australia has been the worst performer, with its 10-year yield rising roughly .30%. On a broader level, Australian bonds have generally underperformed their U.S. equivalents, widening the interest rate differentials between the U.S. and Australia. The reflation-driven nature of this move in rates has been clear, with markets also pricing in Reserve Bank of Australia (RBA) rate hikes earlier than previously expected.|
The Aussie dollar is a pro-cyclical currency, so it was always expected to benefit from a global recovery. However, the speed at which the currency has appreciated has been quicker than anticipated, especially in light of the more dovish than expected RBA meeting on Feb. 3. Certainly, further currency gains are possible but there are reasons why markets are unlikely to see a sharp acceleration from current levels.
The first reason is that the RBA still has plenty of tools at its disposal and is likely to use its March 2 meeting to underscore this, as last night’s $2 billion worth of unscheduled purchases was unable to move yield below target and likely signals growing concerns over market conditions.
Currently, the central bank has two asset purchase programs — its yield curve control (YCC) program and its quantitative easing (QE) program. The QE program was initially at $100 billion AUD but has since been extended by another $100 billion. Comments out of the RBA highlight the bank’s belief that its QE program has been successful in weakening the AUD exchange rate.
As for YCC, this tool has been dormant until earlier this week, when the RBA made its first YCC purchase since Dec. 10, 2020, in response to the move higher in three-year yields. With yields continuing to exhibit support, the possibility for further substantial YCC purchases is real. There is also the possibility that the RBA tweaks its YCC tool at its March meeting next week. Back in February, the bank discussed shifting the focus of its yield target, and should this shift happen, it would be viewed as a dovish development and will likely lead the markets to expect an increased pace of YCC purchases. On a broader level, it is possible that the RBA uses changes to its asset purchase programs to signal its willingness to keep a lid on bond yields.
The second reason to not expect sharp AUD appreciation is the fiscal picture. The Australian government’s fiscal response to COVID-19 has primarily focused on two jobs programs: the Jobkeeper program, which supports current jobs through subsidies to employers, and a supplemental program to the Jobseeker unemployment benefits. Both of these programs are set to expire at the end of Q1, and this is expected to lead to increased job losses.
While the government is expected to keep a number of spending measures, the chances of a significant increase in fiscal spending are low. This then likely marks the start of a change in relative growth dynamics. Australia has consistently been at the forefront of the post-COVID-19 growth recovery, but with the U.S. set to increase fiscal spending versus a pullback in Australia, the relative growth dynamics should change. To be clear, the AUD is unlikely to lose its pro-cyclical qualities, but changes in relative fiscal policies do give the RBA further justification to remain dovish and provide a check on AUD FX strength.
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