- AUD forecasts cut by BMO Capital Markets, updated at Citi.

- But a recovery is in prospect, only it'll be shallower and slower.

- AUD/USD set to rise through 2018 while GBP/AUD holds steady.

© Greg Brave, Adobe Stock

The road to recovery for the Australian Dollar will be shallower and the journey slower than previously thought, according to BMO Capital Markets, who have cut their forecasts for the currency in a mid-year FX update.

Australia's Dollar has fallen by 5.5% against the US Dollar this year and by 3.3% against the Pound as the Aussie interest rate outlook has deteriorated, commodity prices have fallen and the market's appetite for 'risk currencies' has fallen in line with an increase in uncertainty over the outlook for international trade.

This has left the Aussie unit trading beneath its "fundamental value", according to the BMO Capital Markets team, although the outlook for the currency from here on is not nearly as bleak as any of those numbers would appear to suggest.

"AUD/USD is typically thought of as the base metals currency. Although base metals have had a soft H1 of 2018, demand trends are still positive and should still be AUD supportive. Moreover, AUD weakness has substantially overshot base metals weakness. That gap should close at some point," says Greg Anderson, global head of FX strategy at BMO Capital Markets.

The price of iron ore, which is Australia's largest export, fell by more than 20% during the first quarter of 2018 but have since stabilised. Nonetheless, a recovery has been scuppered during the second quarter by a US President intent on reducing the US trade deficit through the use of import tariffs, which has stoked fears of a "trade war" and concern for the global growth outlook.

This fall, and fears over a so called "trade war", came amid a deterioration in Australian economic data, which saw inflation numbers surprise on the downside repeatedly, keeping the consumer price index trapped below the lower bound of the 2% to 3% target, while household pay growth also remained moribund. These domestic dynamics have driven a marked deterioration in the outlook for Reserve Bank of Australia monetary policy.

"RBA Governor Lowe has been remarkably dovish given the macro backdrop. He has talked the market out of expecting a rate hike until July 2019. We think a hike will be needed sooner," Anderson adds. "Australia’s long-term FX fundamentals are solid and improving. Its ‘twin sins’ summed to just -3.2% in 2017, which was Australia’s best twin sins score since 2003. Q1 GDP growth was a blistering 3.1% YoY. Q1 inflation of 1.9% YoY should limit RBA dovishness."

The Reserve Bank of Australia has held its interest rate at a record low of 1.5% for 23 consecutive months, citing below-target inflation and a debt laden household sector that it says is ill-equipped to handle the pressures of higher borrowing costs following years of weak wage growth. Markets do not see a change in policy coming until at least the middle of 2019.

Meanwhile, the Federal Reserve has raised US rates twice in 2018, taking US rates above their Aussie counterparts, and is on course to do so twice more before the year is out. This has incentivised traders and international investors into selling the Australian Dollar and buying US Dollars instead. Similar is true of the Aussie relative to other countries like Canada, the U.K, as well the Eurozone.

Anderson and the BMO Capital Markets team say the RBA is actually likely to raise its interest rate before the middle of 2019 and that, once into next year, markets will become less keen on the US Dollar given the Federal Reserve has pushed its own interest rates almost as far as they are likely to go. Both of these predictions have positive implications for the Australian Dollar.

Accordingly, the BMO Capital Markets team forecast a steady recovery for the Aussie through the rest of 2018 and into next year, with the AUD/USD rate seen rising to 0.77 before year-end and 0.80 by June 2019.

These projections imply substantial upside from current levels but nonetheless, represent donwgrades from the bank's earlier projections. Just three months ago the BMO team had AUD/USD at 0.83 by the end of 2018.

The Pound-to-Australian-Dollar rate is forecast to rise modestly to 1.75 in time for year-end and to 1.78 by the middle of 2019. These are downgrades from earlier forecasts for Sterling, as the Pound-to-Aussie rate was previously seen at 1.80 by year-end and 1.83 once into next year.

The AUD/USD rate was quoted 0.51% higher at 0.7402 while the Pound-to-Australian-Dollar rate was 0.40% lower at 1.7858.

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Citi say Aussie to Resist Downside Pressure

"AUD has been the worst-performing G10 currency versus USD in the first half of 2018. The RBA is unlikely to commence raising rates until Q1 2019, given the underwhelming inflation and consumer spending outlook in Australia," say Citi analysts, in their Citigold Wealth Management mid-year outlook.

But the same analysts say the Aussie might soon find the worst to be over.

"Other indicators including business investment, employment and retail sales activity are gathering momentum and together with an improving external picture due to higher commodity prices, AUD is now starting to resist further downside pressure and is poised to gain against USD."

Commodity prices are key for the Australian Dollar as they form the country's largest earner of foreign currency.

The thinking is that disruptions to global trade posed by the Sino-US spat might in turn lower demand for commodities, thereby impacting a key source of the Australian Dollar's value.

But analysts at Goldman Sachs have told clients that a trade war won't infact interrupt the commodity price rally.

"Concerns about a trade war hurting commodities are overdone, so expect prices to continue higher," Goldman Sachs told clients in a recent note.

Goldman Sachs in fact remains overweight in the asset class and expects commodities to rise 10% over next 12 months, based on the S&P Goldman Sachs Commodities Index.

"The broker believes most commodities subject to tariffs can be rerouted and sold to other markets, averting a supply glut and associated price declines. We agree though we note that higher prices may serve to dampen demand in some areas," says John Mayer at SP Angel in response to the Goldman Sachs argument.

The Citi team forecast the Australian Dollar will rise back to 0.79 against the US Dollar before year-end and to 0.81 by the end of June 2019. They also predict the Pound-to-Australian Dollar exchange rate will fall nearly 4% to 1.73 before the year is out.

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