Markets are underestimating risks of more RBA tightening

Put that all together, and we are not convinced by market pricing that shows only about a 20% chance of a further hike in rates in this cycle.

Incoming Governor, Michele Bullock will preside over her first RBA rate meeting in October. But outgoing Governor, Philip Lowe may choose to deliver his final hike at the September meeting as a welcome gift to her, leaving her only to decide whether she needs to follow this up with another, and we would imagine by then, final hike if the inflation data fails to make further progress.

We do get much more helpful base comparisons again in November and December, but these rely on the seasonal problems hitting agriculture and energy in Australia last year not being repeated. That seems like a fair call, but certainly not a risk-free one when one considers all the things that can go wrong: bushfires, floods, geopolitical interruptions to supply chains. So despite taking a more hawkish than consensus view on rates, we would argue that the risks to our forecasts remain skewed more on the upside.

Australia's inflation

AUD: Ample room for a recovery

The Australian dollar has been the worst-performing G10 currency in the past month, as it faced a combination of external headwinds coming from another round of Chinese growth repricing and the recent risk-off environment, as the two holds by the RBA cooling off domestic rate expectations.

Much of the outlook for an ultra-sensitive currency to global risk sentiment like AUD remains strictly tied to external developments. As shown below, AUD/USD is the second most sensitive USD-cross in G10 to swings in global equity-related risk sentiment, while its correlation with US back-end rates is not higher than other cyclical currencies like NZD, EUR and GBP.

G10 correlations with risk sentiment and US yields

The recent rally in global equities (MSCI World up 7% in the past six months) clearly hasn’t been reflected in AUD price action. Our short-term fair value model – where MSCI World index performance is a variable – has been displaying an obvious tendency in AUD/USD to overshoot on the undervaluation side, which likely reflects the risk premium related to China’s re-rating of growth expectations. The persistence of that risk premium suggests that the Chinese growth disappointment factor is now largely priced into AUD, which could ultimately limit the scope for further downside. Incidentally, we estimate that AUD/USD remains around 18% undervalued in the medium term, according to our real BEER model mis-valuation results.

AUD/USD displaying persistent undervaluation

As highlighted above, we think the domestic picture will also improve for AUD, as the RBA may well have to hike again despite market’s flat rate expectations. The monetary policy story could potentially come through as a positive factor at a time (September, for example) when USD resilience hasn’t abated yet, meaning an RBA-driven bullish pocket for AUD could initially be mostly mirrored in relative strength against other pro-cyclical currencies rather than on AUD/USD. Still, in line with our bearish USD call for later in the year, we expect AUD/USD to rebound back to the June and July 0.69 peaks before year-end, and then find more support above 0.70 in the first half of 2024.