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Fixation with end of easy money puts Australia in the crosshairs

Markets’ fixation with the end of monetary easing is heading Down Under.

Investors and traders are crowding round the Australian dollar, wondering whether the Reserve Bank of Australia will be the next stop in the journey of normalising monetary policy that has so far taken in the US and Canada, and flirted with the UK and the eurozone.

The fluctuations in the “Aussie”, as the currency is commonly referred to, have been pronounced. Since the beginning of June, it has risen 6.5 per cent on a trade-weighted basis.

That has included a rise of 4 per cent against its US counterpart over the past two weeks, touching its highest level in more than two years, followed by a sharp correction late last week. Australia’s 10-year bond yields earlier this month hit their highest level since March.

With key inflation data and a speech from Philip Lowe, the RBA governor, due on Wednesday, followed by the August meeting of the central bank the week after, the coming days will test the mettle of traders in the Aussie currency and bonds. At issue for investors is deciphering what the central bank is trying to achieve with an economy that is strengthening but generating little inflation.

The soundings thus far from the RBA have been unclear. Minutes from the last meeting of policymakers discussed a neutral cash interest rate of 3.5 per cent, a move that prompted fevered speculation of rate hikes, only for deputy governor Guy Debelle on Friday to damp such enthusiasm and declare that monetary stimulus would “likely continue for the foreseeable future”. The cash rate, which the central bank has been cutting since 2011, currently sits at 1.5 per cent.

Even Australian prime minister Malcolm Turnbull weighed in, saying the neutral rate mention was simply a signal to highly indebted household borrowers that rates were “more likely to go up than go down” in the medium term.

Like it or not, the RBA is caught up in the market’s current fascination in whether more and more monetary authorities are minded to end the easy policy that has been a feature since the financial crisis. It faces comparisons with other central banks, such as the Bank of Canada, which heavily primed the market for raising rates, and the European Central Bank, which many traders believe is trying to give away as little as possible about its intentions.

“Is RBA really the next Bank of Canada?” wonder analysts at BNP Paribas. The Aussie looks “under-owned” relative to other commodity currencies, they say, but argue that improving economic news is needed to support rate hike expectations.

And right now, every favourable piece of economic data is sending the Aussie higher, as investors warm to the idea of a rate rise. The economy has shrugged off years of below-trend growth, dating back to the end of the massive mining investment boom in 2012, and is now delivering the best jobs creation performance in several years. Growth is forecast to hit 2.6 per cent this year.

Yet that is not the whole picture for the RBA. Just like many other central banks, it faces sterile wage growth and policymakers are perplexed by low inflation. The consequences of a rate hike on consumers bearing high levels of household debt weigh on the RBA, economists say. The ratio of household debt to disposable income in Australia is about 190 per cent — one of the highest in the world.

A strengthening Aussie is not helping the inflation picture. Every 10 per cent increase in the trade-weighted value of the currency knocks 0.3 per cent off the level of inflation, according to analysis from BNP Paribas.

Yet as long as US Federal Reserve caution and poor data keep downward pressure on the US dollar, the Aussie may still have a tailwind.

The dovishness of Fed chair Janet Yellen because of concerns about meek inflation, despite leading the way on rates normalisation with four rate rises in 18 months, is setting the market up for a positive risk-on move for the next couple of months, says Michael Sneyd of BNP Paribas. And that risk appetite “should be rosy for the Aussie”.

An ever-strengthening currency poses the danger for the RBA that the value of currency is out of the kilter with the economy. “What they don’t want is a strong Aussie not justified by fundamentals,” says forex analyst Valentin Marinov, of Crédit Agricole.

The problem is that the appetite of investors to trade the end of monetary easing looks insatiable. The Aussie’s rise is “another classic case of markets front-running central bank policy”, says ING.

So far, says Mr Sneyd of BNP Paribas, the reaction of the currency has been extreme given the move in rates expectations. The probability of a rate rise by the end of 2017 stands at no more than 30 per cent, “but the movement in the Aussie is pricing in more than that”, Mr Sneyd says. “The currency looks elevated at these levels, and the concern is the market getting ahead of itself.”

If June inflation comes in below-par it may be enough to silence talk of a rate hike for the time being, but the impact may be shortlived. Low inflation data in the UK have put to bed the prospect of a Bank of England hike in the near-term, yet the same occurrence in New Zealand led to only a fleeting depreciation of the kiwi dollar.

Instead, the kiwi marched to its highest level in two years after finance minister Stephen Joyce said US dollar weakness was likely to continue.

That, ultimately, is why the Australian dollar will continue to climb. Its weak American counterpart is doing much of the heavy lifting.