The Reserve Bank of Australia (RBA) cut rates by 125 basis points in 2012 as Australian business conditions continued to weaken. The mining sector capex slowdown, lower bulk commodity prices, ongoing fiscal contraction (particularly by the state governments who need to maintain their high credit ratings) and the higher Aussie dollar have all contributed to the creation of challenging operating conditions. The March and August corporate reporting periods last year confirmed this with the deceleration of earnings combined with a very subdued earnings outlook.

Chart 1: Australian Business Conditions. Broad based business survey illustrates the tough operating environment. Lower rates and a lower AUD will help.

The current Australian cash rate of 3.0% may be at the recent global financial crisis (GFC) lows, however it remains the highest yielding cash rate (in both real and nominal terms) among the developed economies globally. Further, the funding costs are higher versus the pre GFC levels, therefore the average domestic mortgage (or small business loan) remains historically high. Chart 2 shows the RBA Cash Rate historically and the Implied Cash Futures Curve into early 2014. The market is looking for lower rates and for rates to remain lower for longer.

Chart 2: RBA Cash Rate and the Implied Cash Futures Curve. The market looking for lower rates ahead.

Higher relative cash and bond rates (real and nominal), combined with a high Australian dollar in trade weighted terms effectively creates tighter monetary conditions. A lower rate environment would help.

Aussie dollar to remain expensive

The Aussie dollar spot rate at about 1.04 US cents is not only well above any fair value model, it is above the daily one-year average, and this is in a period of 125 basis points in rate cuts!

The point expressed many times this year has been the fact that the Aussie dollar is no longer just a commodity currency. Global investors are treating the currency as a high yielding and highly rated income currency (higher relative cash and bond rates in both nominal and real terms). Further, the Australian dividend yield is well above the global developed market equity bourses due to the higher payout ratio of the local ASX200 index. Chart 3 shows the Aussie dollar versus the CRB Commodity price Index.

On a Purchasing Power Parity (PPP) basis, the Aussie is expected to be around the 0.76 level. This ‘law of one price’ theory is best known as the Big Mac Index for many. It is broadly theoretical and more aligned to very long business cycles and time frames. Given the current relative drivers for yield, a high quality credit rating and commodity prices going forward, the Aussie dollar is set to remain expensive compared with many fair value currency models. Our Australian dollar forecast is currently 1.02 US cents for three, six and twelve months respectively (UBS WM forecast).

Chart 3: AUD and the CRB Commodity Price Index. The AUD is no longer just a commodity currency as global investors chase yield.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.