Final call: Fed’s $US2tr flight path a risk for Aussie dollar

It’s a slightly odd world when a $US2 trillion event is playing out behind the scenes. But that is what the US central bank, the Federal Reserve, is hoping to achieve as it reduces the size of its balance sheet – the assets it owns – in coming years.

Of course there’s always the risk that this unwinding doesn’t play out so quietly. There’s also the obvious uncertainty emanating from the new Trump administration. A key impact of all of this – including the US Fed’s interest rate hikes – on Australians is likely to be what happens to the value of the Australian dollar.

But those planning an overseas jaunt any time soon can rest easy, for now.   

At its June meeting, the Fed delivered it’s second 25 basis point increase in the Fed Funds Rate for the year. The rate-setting policy committee, the FOMC, also flagged a third hike this year, three more in 2018 and another three in 2019 which would take the so-called Fed Funds Rate to 2.9 per cent by the end of that year.

That is notable for markets – and pretty remarkable – given the rate has been around zero per cent for the last decade.

However, there’s a lot of debate in markets about the outlook for US rates given stubbornly low inflation and fears of what will happen once years of extraordinary stimulus is pulled back. Combined with the potential reduction of central bank stimulus around the world in places such as Europe, it’s a unique event most people have never lived through. At Westpac, we believe the FOMC’s hiking cycle will peak at a much lower level of 1.875 per cent, most likely in September 2018. Why? Because we simply do not believe that US productivity and inflation will rise significantly.

Aside from interest rates, just as important is the Fed’s second area of stimulus removal that has recently been flagged to begin by the end of this year: the so-called $US2 trillion “normalisation” of its balance sheet.

In simple terms, this complex process involves the Fed allowing some of the bonds it purchased during and after the GFC – in order to keep interest rates low – to mature without reinvesting the proceeds back into the bond market. The significance of this is that newly issued bonds will increasingly have to be priced and bought by the private sector rather than the Fed, ending years of artificial buying support.  
 
The Fed’s plan is to let up to $US6bn of maturing US Treasury bonds roll off each month initially, with this pace being gradually increased. In total (including other maturing assets), the maximum pace of “normalisation” will rise to an annualised pace of $US600bn from late 2018. The entire process will take place over a number of years (at least four) and result in the Fed’s balance sheet being reduced by more than $US2trn.

Given the massive size and complexity of this process, we and many others will be paying close attention to the private sector’s appetite for newly issued bonds and what happens to the US 10 year Treasury bond yield, a key financial benchmark globally.

Higher interest rates in the US typically push the US dollar up and other currencies down. But in this instance, improved growth in the Australian economy in coming months after a weak start to 2017 should hold the Australian dollar up. By the end of the year, we expect the Australian dollar will only ease to around US73c from US79c currently.

The view on the Australian dollar for 2018 is less positive. Pressure from declining commodity prices and the US Fed’s interest rate hikes are expected to push the currency down to US65c by the end of next year. This isn’t all bad news though, with Australian exporters to become more competitive. In time, a lower Australian dollar should also lead to greater employment and investment by these firms as well as confidence in the Australian economy.

While all this is going on, it is also worth remembering another factor: President Donald Trump and his policy agenda.

Part of the reason that the market sees large downside risks to the Fed’s forecasts for interest rates is that there has been no progress in Washington on President Trump’s grand plans. If this situation continues, that would raise the risk of lower US interest rates and a higher Australian dollar. But equally, if progress was to occur, then the market and the Fed could price in stronger US economic growth and higher interest rates. That would be a further negative for the Australian dollar come 2018. As above, the other key risk to remember is the ever-present possibility that financial market volatility will return with force. If the Fed’s plan doesn’t eventuate as it hopes, this is a real possibility.

This article is general commentary and any view or opinions expressed in this article are the author's own and may not necessarily reflect the view or opinions of Westpac. Any commentary contained in this article is not intended as financial advice and should not be relied upon as such by you.