Will 2017 be the year that global central banks raise interest rates?

Growth and inflation data from the major markets are showing signs of life. This is translating into a wave of commentary on, and a degree of uncertainty about potential action that the world’s central banks may take next.

Consensus is that the next step of the US Federal Reserve (Fed) will be to increase interest rates by 25 basis points after its meeting this month. However, forecasts for moves by the European Central Bank (ECB) and People’s Bank of China (PBC) are more disparate.

With its steady economy, what impact will the US have on an Australian decision?

Despite political uncertainty, the US economy is travelling reasonably well. Assuming this strength continues and the Fed raises rates three or four times this year, this should over time free up (at least in principle) other central banks to ‘normalise’ their interest rate policies – that is, if local economic and geopolitical stresses allow.

In the case of our own economy, it seems that the Reserve Bank of Australia (RBA) does not want to lower rates and thereby risk stoking the already heated property markets in Sydney and Melbourne. However, given the generally weak wages growth and slow employment growth outside of New South Wales and Victoria, it would likely appreciate injecting some form of additional stimulus.

Conventionally, a widening differential between US and Australian interest rates is one factor that influences currency strength or weakness. If, as markets anticipate, the US raises rates and the RBA sticks firmly to its current position, the Australian dollar (AUD) should weaken against the US dollar (USD), potentially providing some stimulus to the Australian economy.

Reality, as always, is more nuanced. This interest rate differential as a driver of exchange rates is influenced by several other factors – the best example being commodity prices. For the last year or so, the Australian dollar has traded between about 72 and 78 US cents. When it nears 78 cents there seems to be an increase in commentary that the Australian dollar is going to continue to strengthen, but when closer to 72 cents, the focus is more on how much it is likely to weaken. The long run average AUD/USD rate is around 76.5 US cents – not far from where we sit now.

So, will the RBA get a helping hand from a weaker Australian dollar?

The question remains as to whether there are factors that can knock the dollar out of this range? As well as relative interest rates, the path depends to an extent on where prices for our major commodity exports go from here. If commodity prices continue upwards – improving our terms of trade – the Australian dollar should strengthen, potentially preventing the RBA from increasing rates, and possibly even forcing them to drop interest rates. Lower commodity prices should mean reducing terms of trade and a weaker AUD.

Our medium-term view on commodity prices is that despite decent Chinese economic outlook, the demand for commodities driven by stimulatory measures in China is waning. Additional productive capacity is opening and we see a fall in commodity prices coming. This translates into our view that the Australian dollar should tend to trade lower.

However, in the short run, we have slightly less conviction for a lower Australian dollar when the dollar is less than 74 US cents and more when it is above 77 US cents – and this has been our view for the past two years. We believe the interest rate differential needs to widen (i.e. US rates need to rise relative to Australian rates) and terms of trade need to fall if we are to break out of the current AUD/USD trading range.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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