STRONG LABOUR MARKET, STRONG DOLLAR

Chief Economist's View 

Download the PDF version including our economic update by region here: Strong Labour Market, Strong Dollar. 

The Australian labour market produced another cracking result over January, with just over 29K jobs added in the month. Employment is now just 56K, or ½ a percent, shy of the pre-COVID level of employment of around a year ago. But to temper our enthusiasm, we must remember that with the passage of a year 110K workers have entered the workforce, among them our young people who are looking to start their work careers. Accounting for these additional workers, there are currently 110K more people looking for work than a year ago and we have 156K more people unemployed than we did a year ago. And even though the unemployment rate is coming down, at 6.4% it remains high and a long way from the Reserve Bank of Australia’s (RBA) full employment rate of 4.5%.

In last week’s Brief, we noted that unemployment has also been falling in the US and elsewhere around the globe. Are we keeping pace with the rest of the world? In the US, over 16 million jobs have recovered since the low point for US employment back in April last year, but this still leaves the US market down by 8.6 million jobs compared to January last year.

To put that into perspective, US employment is still 5% less than a year ago, an order of magnitude worse than Australia, which as mentioned is down by a mere 0.5%. If we are outpacing the rest of the world in our recovery, what does this mean for our currency? Typically, it would mean that our economy would be homing in on full employment more rapidly than the rest of the world, labour markets and markets for goods and services would be tightening and our interest rates would be rising faster than elsewhere. This would typically lead to upward pressure on our exchange rate if our international terms of trade remained stable and the RBA did not attempt to offset the rise in AUD with an easing of monetary policy.

Does this mean that the RBA’s extension of QE, announced at its February Board meeting, will be too little too late to stem further increases of the currency? Over the December quarter, Australia had a very sharp rise of over 50% in the terms of trade as our bulk commodity export prices, such as iron ore, surged. Since the end of last year, our terms of trade have stabilised and the RBA extended its QE program and the AUD has largely tracked sideways. It must also be remembered that two thirds of the rise in the AUD since last June has been due to general USD strength against all currencies.

Against a basket of currencies of our major trading partners, including China, the rise in the AUD is just 4% cf with a rise of 12% rise against the USD. This means that the damage of a higher currency to our economy through an adverse impact on international competitiveness is far less than it would seem if you measured the currency move by the AUD/USD exchange rate rather than our trade-weighted index. So, does the RBA need to worry about the currency, and if so, how should it go about controlling it? While currency moves depend on a range of factors beyond the RBA’s control, such as the terms of trade and international investor sentiment, the RBA can influence the currency through its power to manipulate Australian interest rates.

The RBA can manipulate interest rates in two main ways: through setting the cash rate, which tends to anchor short term interest rates, and by QE, which impacts interest rates of bonds of longer maturities. At the moment the RBA is using both levers: setting the cash rate and the three year bond yield close to zero and doing QE to lower the interest rates on government bonds beyond 3 year maturity. By lowering longer dated bond yields, the RBA lowers the attractiveness to international investors of Australian bonds and therefore lowers the demand for AUD to buy such securities, which in turn takes pressure off the exchange rate. How much scope currently does the RBA have to force the AUD lower?

This depends on how much lower the RBA can drive interest rates. Currently, the RBA has set the cash rates at around zero, with no intention to drive cash rates negative. But at longer maturities, interest rates are much higher with the Australian 10-year yield currently trading at 1.4%. Hence, the RBA could increase its QE program, buy bonds at longer dated maturities and drive those interest rates much lower; close to zero if needs be.

So, what is the end game? Where will the AUD end up and will the RBA be forced to extend, yet again, its QE program? Our view is that the RBA will be more comfortable with the AUD below US75c than above US75c. But the RBA’s comfort zone depends partly on what’s driving our currency.

If it is the terms of trade, then the RBA will be more comfortable with a strong dollar as it reflects higher prices for our exports and, given that with international borders still closed, the higher dollar does not do as much damage to our economy by undermining the competitiveness of our service exports such as tourism and educational services. If the strength in the dollar is due to rising Australian interest rates, the RBA will be more concerned and we can expect further QE. Our guess is that the Australian dollar will stall at current levels and potentially drift lower as our terms of trade retreat. If not, expect more QE from the RBA.

Table 1: Financial market movements: 11 - 18 February 2021

Source: Bloomberg