AUD/USD outperforms after Q1 GDP data surpriseScope for RBA pricing to creep higher in short-termBut Fed expectations rising, further upside possibleCorrelation with fragile ‘risk’ markets near 3-yr highCommodity prices relationship offers a partial offset

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The Australian Dollar outperformed in the mid-week session but central bank policy expectations on boths sides of the AUD/USD equation could soon constrain the antipodean currency, which is also trading an elevated correlation with fragile stock markets, according to Westpac analysis.

Australia’s Dollar was the top performing G10 currency on Wednesday after Australian Bureau of Statistics (ABS) figures revealed a sizable 0.8% increase in GDP for the first quarter and from an economy that financial markets had expected to expand by a lesser 0.6%.

“Real GDP rose by 0.8% in the quarter to be 3.3% higher over the year. The lift follows a 3.6% (revised up) gain in Q4 21 and shows the Australian economy entered the interest rate hiking cycle in a bright position,” says Belinda Allen, a senior economist at Commonwealth Bank of Australia.

“The Australian economy has continued to expand in Q2 22 to date. There are growing signs of capacity constraints impacting economic activity as well as rising prices. CBA high frequency credit & debit card data shows signs of moving sideways in May after recent strength,” she added on Wednesday.

Source: Australian Bureau of Statistics (ABS).

Wednesday’s figures had no obvious impact on market pricing of the Reserve Bank of Australia interest rate outlook although some economists say there were details inside in the GDP report that could lead the RBA to contemplate a larger-than-usual increase in its cash rate for June.

“While GDP was in line with our expectations, today’s data confirmed the very strong average hourly wages growth that yesterday’s Business Indicators report implied. Our estimate of 5.3% y/y is well above our expectations from just a few weeks back, certainly much stronger than the signal from the Wage Price Index,” says Felicity Emmett, an economist at ANZ.

Above: AUD/USD at hourly intervals with NZD/USD and upside down or inverted USD/JPY. Click image for closer inspection.

“This suggests to us that policy needs to lean more strongly against the broadening of inflation pressures. As such we think the strength of the price and wage measures in the GDP data should be enough to convince Governor Lowe that “there is a very strong argument” to deviate from a regular 25bp move and get the cash rate a little higher a little bit faster,” Emmett also said Wednesday.

The RBA lifted its cash rate by 25 basis points from 0.1% to 0.35% in May and some measures of market expectations suggested on Wednesday that many already see the benchmark rising to 0.70% in next week’s decision.

Above: Overnight index swap market implied expectations for RBA cash rate following each meeting. Source: Westpac.

Much about the Australian Dollar outlook likely depends on the how far the RBA lifts its cash rate next week and on the pace at which it’s perceived as being likely to move at in the months ahead, although likely constraining the AUD/USD pair is a variety of other factors.

“Focus for treasury traders in the coming days and weeks will shift to the impact of the Fed’s balance sheet reduction, or QT, that is set to kick off today. Also, any further increase in hawkish Fed rhetoric is on the radar after Fed Chair Powel met with President Biden at the White House yesterday,” says John Hardy, head of FX strategy at Saxo Bank.

“President Biden met Fed Chair Powell yesterday and said he respects central bank independence – the obvious statement to make in a public setting. He made Powell in charge of fighting inflation, perhaps laying the ground for putting the blame of an economic slowdown on him a few months down the line,” Hardy and colleagues wrote in a Wednesday market commentary.

The process of quantitative tightening began in the U.S. on Wednesday and will see the Federal Reserve (Fed) shrinking its mammoth balance sheet in increasingly large increments during the months ahead, implying upside risks for U.S. government bond yields.

Above: AUD/USD shown at daily intervals with selected moving-averages as well as Fibonacci retracements of early and mid-April declines suggest multiple technical resistance overhead for Australian Dollar. Click image for more detailed inspection.

Rising U.S. yields could pose a risk to the Australian Dollar and more so in any market where the RBA elects to raise its interest rate at a lesser pace than that of the Fed, while these risks could also yet be buttressed and bolstered by the pace at which the Fed raises its interest rate in months ahead.

However, these are not the only risks lurking on the path ahead of the Australian Dollar and many other currencies.

“The correlation between the Aussie and the MSCI World Index has tightened, the 30-day rolling correlation up to 0.77 and the 60-day to 0.73. These are at the upper end of the ranges of the past 3 years. Still, commodity prices cannot be forgotten for the Aussie’s daily changes. The 30-day correlation with the Bloomberg Commodity Index has risen from a modest 0.24 end-April to 0.60,” says Richard Franulovich, head of FX strategy at Westpac.

“Near term, the correlations suggest a limited role for, say, yield spreads to guide the Aussie, but of course the direction of energy prices ties into the difficult equation facing central banks and in turn to whether equity prices can stabilize and look ahead to what we expect will be a more supportive global environment later in 2022,” Franulovich wrote in a Wednesday research briefing.

Source: Westpac.