When Central Banks Align

Although the Reserve Bank of Australia (RBA) and the US Federal Reserve have nearly opposite biases at the moment, with the former maintaining a dovish easy-money approach while the latter is cautiously hawkish, somehow their policymaking temporarily aligned this week.

Over the past several weeks, the RBA has engaged in an extensive jawboning campaign in an effort to talk down the Australian dollar. The relatively strong Aussie has been a major headwind for the country’s exporters, including the resource sector, and the central bank has been trying to engineer a decline in the exchange rate to help boost the economy.

Meanwhile, after multiple rounds of its so-called quantitative easing (QE) program, the Fed has finally announced the inception of the long-awaited taper of its extraordinary stimulus. The central bank will start to pare its $85 billion per month bond-purchasing program by $10 billion in January.

As we’ve seen since the Fed first announced earlier this year its plan to eventually curtail what some had jokingly dubbed “QE Infinity,” mere knowledge of its intent is enough to cause financial markets to tighten, while having broader repercussions in the global economy, including on exchange rates.

Despite the fact that the RBA has been on a rate-cutting cycle since late 2011, the Australian dollar defiantly traded above parity with the US dollar for much of the period since then. It wasn’t until the Fed first broached the topic of the taper earlier this year that traders started to abandon the Aussie, and the currency fell below parity in earnest.

Over the past six months, the Aussie’s movements seem to have been closely correlated with traders’ expectations about when the Fed would finally commence its taper. When that action was deferred, the RBA had to resort to other methods to force the country’s currency lower.

After all, rate cuts alone hadn’t been sufficient to undermine the Aussie. And with the RBA’s short-term cash rate at an all-time low of 2.5 percent, the RBA was loath to cut rates yet again, especially given the potential for such a move to provide additional fuel to what some fear is an overheating housing market.

Instead, RBA Governor Glenn Stevens has mused that foreign-exchange intervention can be effective, if used judiciously. Furthermore, he even said it would make more sense for the Aussie to trade near USD0.85 than the levels in the mid-90s that prevailed at the time of this observation. More recently, according to The Sydney Morning Herald, Mr. Stevens further elaborated that the Australian dollar trading above USD0.90 would not be sustainable for the economy over time.

Fortunately, the RBA’s jawboning campaign has been fittingly capped by an actual Fed taper, a rare feat of perfect–though presumably coincidental–timing. Following the Fed’s announcement, the Aussie hit a new low for the year, near USD0.886, down 16.4 percent from its year-to-date high in early January. At the moment, it’s currently trading a bit higher, near USD0.892.

Now that the Fed has finally committed to a concrete action, as opposed to simply debating the timing of its inception, the question is whether that’s enough to continue pushing the Aussie lower.

With the dovish Janet Yellen set to take the helm of the Fed in January, the US central bank should continue to carefully navigate its tightening process, which will, of course, depend on sustained improvements in economic data. That means the taper will likely be implemented in an incremental manner, halt for a period, or even revert to former levels in the event the economy weakens again.

Beyond that, Ms. Yellen extracted an important concession from the departing bank chief. The Fed has committed to maintaining low rates far longer than it had indicated earlier this year, when it said its first rate hike might occur around the time the unemployment rate falls to 6.5 percent. Instead, the Fed said it would hold short-term rates at current levels until unemployment falls well below 6.5 percent, especially if inflation remains below the central bank’s 2 percent target.

If the Fed’s taper proceeds slowly, then traders could fixate on the newly extended period of short-term rates, which might mean renewed strength for the Aussie, or at least a base of support above the RBA’s desired threshold. Barring a sudden acceleration in US economic growth and employment, that means the Australian central bank may be forced to cut rates yet again sometime next year. But at least in the near term, the Fed’s taper should add downward pressure to the Aussie.