- Reserve Bank of Australia to raise rates in 2018 say Commerzbank.

- AUDUSD forecast downgraded, now set to "appreciate slowly" in 2018.

- GBP/AUD forecast upgraded, now set to fall just 2.2% before year-end.

© kasto, Adobe Stock

The Australian Dollar will begin to "appreciate" against the US Dollar and Pound in the second half of the 2018 year, according to the latest set of forecasts from Commerzbank, as the Reserve Bank of Australia shifts it monetary policy stance and begins to raise interest rates.

However, before then, Aussie Dollar exchange rates are likely to set new lows as fears over a possible trade conflict between the US and China keep investors cautious, the RBA sits on hold and other central banks elsewhere in the world raise their own interest rates.

"The Australian economy is not only likely to suffer particularly from an escalation of the conflict due to its proximity to China but also due to the fact that growth over the past years was mainly driven by foreign trade. Domestic consumption on the other hand still leaves something to be desired," says Esther Reichelt, an analyst at Commerzbank.

Fears of a so called trade war have escalated since March when the White House and China began a tit-for-tat series of protectionist trade actions, with the US imposing punitative tariffs on China and vice versa.

Given the Australian Dollar's sensitivity to global risk appetite and the Antipodean economy's dependence on China and global trade, the threat of a trade conflict has compounded the Aussie Dollar's woes during recent months. But the resulting currency weakness may have played right into the hands of the RBA.

"We believe that the RBA will continue to critically monitor the AUD level for the foreseeable future, which argues against a significant appreciation of the AUD - at least until inflation has returned to the target range on a sustained basis. For this reason, RBA will also try to keep interest rate expectations aloof," Reichelt adds.

Above: AUD/USD rate shown at daily intervals.

Australian interest rates have been held at a record low of 1.5% for approaching two year now and, at the time of writing, markets do not expect a change in RBA policy until well into the 2019 year. However, other central banks have long-since begun to raise their interest rates as the global economic recovery from the financial crisis enters its advanced stages.

This has been by-far the greatest source of downward pressure on Aussie exchange rates this year. But what's more, the direction of travel for other central banks and bond yields is also opposite to that seen down-under, which means the currency may continue being crushed beneath the weight of unfavourable interest rate differentials for a while to come.

After all, the Bank of Canada is firmly entrenched in an interest rate hiking cycle while the Bank of England and European Central Bank are also in the process of withdrawing stimulus from their respective economies.

"For the foreseeable future, the US dollar will still be in the lead, as it will appreciate due to the gradual interest rate hikes by the Fed. However, the AUD will begin to appreciate at the end of 2018, as the market will then increasingly speculate that RBA will raise its key interest rate," Reichelt says.

In the current world where markets are heavily focused on relative interest rates, the Aussie Dollar has been shunned by investors in favour of alternatives where either rates are already higher, or where the direction of travel is more positive. The only thing that will prevent this from continuing during the months ahead is signs of a change in RBA policy.

Above: Pound-to-Aussie-Dollar rate shown at daily intervals.

There is scope for markets to become more optimistic about Australian interest rates later this week, on May 16, when the first quarter wage price index is released. However, the last set of figures were a disappointment as they showed pay growth driven entirely by one-off changes in public sector pay and the minimum wage.

Wage growth can have a significant influence over demand in an economy and so it is also important for inflation and interest rate expectations. While it remains to be seen whether 2018 will bring the long-awaited turn for the better in Australian household finances, a positive number Thursday would provide some temporary respite to the Aussie.

"In the first quarter 2018, inflation is still likely to remain below the inflation target, but will then slowly rise into the target range. Since we expect the growth outlook to remain positive as well, despite increased risks for global trade, we see room for an increase in interest rates already this year," says Reichelt.

FX and Interest Rate Forecasts

Reichelt and the Commerzbank FX team are an outlier in that they expect the Reserve Bank of Australia to raise interest rates before the year is out when the market more generally does not anticipate a move from the RBA until the second half of 2019. The interest rate derivative market implied cash rate on June 04, 2019 is just 1.70%, which suggests only an 80% probability of a change in policy by then.

"However, the RBA's concern about an AUD that is too strong should slow the pace of appreciation and allow only a slow upward movement in AUD-USD. In the course of 2019, the slowing pace of interest rate hikes by the Fed and a weaker USD as a result of this suggest that the upward trend in the AUDUSD will continue," Reichelt adds.

Commerzbank forecasts the AUD/USD exchange rate will fall close the year at 0.75, which is exactly the same level as the market price Tuesday, but that it will dip as low as 0.74 during the third quarter before recovering in time for year-end. This is a downgrade from the 0.82 forecast issue by the bank back in April.

They forecast the Pound-to-Aussie rate will fall steadily throughout the rest of the year, although by less than was previously projected, from the current market level of 1.80 to 1.76 before the end of December. This is a modest upgrade from Commerzbank's April projection of 1.65.

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