Long-term Australian dollar and inflation forecasts
A number of variables could influence inflation and the strength or relative weakness of the Australian dollar, writes Stephen Nash, who explores a range of scenarios.
Inflation-linked bonds provide protection against spikes in inflation, and at current low prices with attractive yields over the Consumer Price Index they also offer high real yields in this low interest rate environment.
In this article we briefly review the various factors that could impact longer-term expectations of the Australian dollar (the AUD) and Australian inflation. Then, we examine various scenarios for both the AUD and for inflation, including:
- The low scenario, where a confluence of factors could lead the AUD, or inflation, lower than expected;
- The expected scenario, our estimate of the AUD and inflation rates; and
- The high scenario, where a confluence of factors could lead the path of the AUD, or inflation, to higher than expected levels.
AUD forecast
In the short term, the main influence on the AUD will be both the prospects for global growth and commodity prices, as well as the level of domestic interest rates.
If the global economy remains weak, then the level of the AUD will remain firm, as the major currencies that the AUD trades against will remain weak.
However if growth expectations slump too much, then the commodity outlook will collapse and the AUD may suffer.
If prospects for global growth improve, and the major currencies, like the USD strengthen, then the AUD may weaken against these currencies. A list of specific factors that might impact the AUD, as they occur in the various scenarios, are listed below:
Low scenario
- Expect that growth continues to be on the softer side of expectations, and that the transition from mining-led investment continues to be problematic, meaning that rates will be biased lower over 2013 and beyond, which will lead the AUD toward the low scenario.
- Chinese growth is hostage to its export market, which remains depressed in Europe and barely positive in the US, meaning that commodity prices will remain contained, thereby constraining the level of the AUD.
- Middle Eastern issues continue to elevate oil prices, with Syria a potential crisis area along with Gaza and Iran. Higher oil would depress global growth in major economies, thereby constraining strength in major currencies. A new crisis will see the oil price increase towards USD 150 (West Texas Intermediate, WTI), which will depress growth in the major economies, cutting demand for commodities and lowering the AUD to some extent.
Expected scenario
- An easing in monetary policy will occur in AUD, yet possibly a little more slowly than the market currently expects, which should bring the AUD more towards the expected scenario.
High scenario
- Search for reliable and liquid sources of yield (AAA-rated Commonwealth Government bonds) continue to support the AUD in the short term, in the context of the recent UK downgrade and further European sovereign downgrades in 2013, which will lead the AUD towards the high scenario.
- AUD will be eventually impacted by a gradual lift in global activity, and the consequent firming of major global currencies, especially the USD, around 2015-16. This should lead to a decline in the AUD, towards 2015-16, as reflected in most scenarios.
- Continued sub-par growth in US, leading to firming of the AUD against a weaker USD, supporting the high scenario.
- Delay of budget cuts in the US, which will continue to weigh on investment and growth of the USD, thereby holding down the USD and enhancing the AUD.
- Ongoing European recession fuelled by dysfunctional government and fiscal austerity, with the European Central Bank.
- (ECB) holding everything together, which will depress the EUR and boost the AUD.
- Europe to endure continued credit difficulties, where the threat of issuer default elevates spreads and depresses the EUR and STG, while supporting the AUD.
AUD Forecast – summary
These factors are supportive of the following three scenarios. Note how the expected scenario has the AUD appreciating until 2015-16, when the global economies are expected to lift output and rates.
As global rates rise, the AUD will become less attractive on a yield basis and should, at that point, moderate in value (see Figure 1).
Inflation forecast
In the short term, the main influence on the rate of inflation will be the level of the AUD and the fortunes of the current government in the election year of 2013.
Most agree that a change of government will occur, and the implication of that will be a reversal of the carbon price legislation and some moderation in inflation in the June 2013 to June 2014 financial year (in the absence of other factors).
No large decline in the AUD is expected in the short term, unless either a recovery in the major economies, such as the US, occurs or a decline in growth causes further large declines in commodity prices.
A list of specific factors that might impact the AUD in the various scenarios, are listed below:
Low scenario
- Expect that growth continues to be on the softer side of expectations, and that the transition from mining-led investment continues to be problematic, meaning that inflation trends towards the low scenario.
- Continued sub-par growth in US, will lead inflation lower.
- Delay of US budget cuts, as well as the ongoing threat of the sequester, will continue to weigh on investment, leading demand lower, as well as inflation .
- Reversal of the carbon price legislation as implemented by the Labor government, under a Coalition government, should also lead to some unwinding of current carbon price-related inflation, meaning inflation may trend towards the low scenario.
- Ongoing European recession fuelled by dysfunctional government and fiscal austerity, with the ECB holding everything together, once more leading inflation lower through very low levels of demand.
Expected scenario
- Europe to endure continued credit difficulties, where the threat of issuer default elevates spreads, leading inflation lower.
- Savings rate to remain high, controlling asset price growth, and credit rationing to the property sector will constrain construction in the absence of Federal infrastructure initiatives – meaning inflation should be constrained in the expected scenario.
- A lift in global growth around 2015-16 should lead the rate of inflation higher, as reflected in the rise in expected inflation, in the longer part of the forecast.
- Chinese growth to remain hostage to the export market, where Chinese domestic consumption cannot quickly be increased, meaning over-supply in China should translate to lower inflation and contained growth.
High Scenario
- Concerns in the Middle East may force the oil price up and lead the rate of inflation higher than 3 per cent, as oil price rises flow through into the general level of prices as reflected in the high scenario.
- A slump in global growth forces down the AUD and the lower AUD increases domestic inflation.
Inflation forecast – summary
These factors are supportive of the following three scenarios. The high inflation scenario is mainly driven by the threat of escalated conflict in the Middle-East, driving oil prices to around USD150 (WTI) – see Figure 2.
While our expected scenario is not for high inflation, a higher scenario can be foreseen, especially if tensions in the Middle East spill over into oil prices.
Syria remains a major global concern, and the Syrian conflict threatens stability on many borders, including the Turkish border. Further escalations of the conflict are highly likely.
Also, Israel remains very concerned, not only about Hamas in Gaza, but about the nuclear capabilities of Iran.
Specifically, Iran has been subjected to severe economic sanctions by the US and the EU, and is now suffering as a result.
It would be quite reasonable to assume these tensions, from a somewhat paranoid Israel and a weakened and increasingly desperate Iran, could spill over into a conflict that would lift global oil prices and spread inflation across the globe.
Conclusion
Inflation remains the central problem for most forms of saving, so that using inflation-linked bonds (ILBs), as a direct form of insurance against inflation, should be seen as a sign of sound portfolio design, especially when ILBs are not expensive.
Specifically, if you can insure against a high-inflation scenario by buying ILBs at a real return of over 4 per cent, then you are getting well paid to cover this central investment risk.
Given that 4 per cent over inflation is very close to the expected long-run return of equities, the opportunity in ILBs, when the investor maintains in a senior position in the capital structure, remains quite significant for many investors.
Even if the higher than expected inflation scenario does not play out, the underlying value of ILBs (current discounts to face value) will probably be competed away over 2013, as the low return and low growth environment sees any higher yield instrument aggressively bought, leading to the eventual elimination of 4 per cent real yields.
Dr Stephen Nash is director – strategy and market development at FIIG.
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