AUD Forecast Q2 2022: A Look at Commodities and Central Banks

Commodities Contribute to Profitability 

Prior to the Russian invasion of Ukraine, commodity prices favored the AUD/USD. The conflict's terrible reality prompted a broad swath of the global community to impose heavy sanctions on Russia. Energy, industrial metals, precious metals, and soft commodities have all seen huge increases in price as a result of the restrictions. This is the entirety of Australia's exports.

Spreads on Interest Rates Can Only Do So Much for the AUD

The healthy domestic economy has resulted in the headline consumer price index rising above the Reserve Bank of Australia's target range of 2-3 percent, printing at 3.5 percent year on year through the end of 2021. For the same time, the RBA's preferred measure of trimmed mean came in at 2.6 percent. According to the RBA, inflation will continue to rise through the end of 2022 before dropping in 2023.

According to some analysts, this episode of inflation is 'cost-push' rather than 'demand-pull'. The US Federal Reserve coined the term 'transitory' to refer to such a concept. This thesis has two flaws.

If the increase in costs for businesses and producers was only temporary, the cost-push argument might be valid. However, the increased costs at the factory gate have remained higher for a longer period of time than expected. The 2020 fourth quarter producer pricing index (PPI) is on track to go below the yearly level. Given the current context, the next print is highly likely to show a significant upside result. This forces businesses to choose between margin compression and passing on the price increase.

Thus far, accountability has been delegated, and any profit-driven CEO is likely to continue down this path. Consumers are already seeing price increases, which, according to anecdotal evidence, have escalated. Employers have already begun revising wages to account for the increased levels of inflation. High inflation expectations are becoming established, which complicates inflation targeting.

The second factor to consider is the policy itself. At 0.10 percent, the RBA's cash rate is accommodative. Household balance sheets remain as robust as they have ever been. As a result, demand-pull inflation occurs. If policy were close to neutral (R*), whatever that might be, demand-pull inflation might be ignored. This is not the case; customers can accept higher prices in the short term as a result of slack policy. In many cases, increased demand has resulted in significant price increases.

It is feasible that the RBA may assess the Federal Reserve's policy blunder and act sooner than previously signaled. They have a pattern of saying one thing and then doing another shortly afterwards. The first quarter inflation data is scheduled to be released on April 27th. Tuesday, May 3rd, is the RBA meeting.

The market is presently anticipating a rate hike in June. A strong CPI result could drive them to act sooner than the market anticipates.

Taking all of this into account, the RBA is unlikely to overtake the Fed in terms of rate increases. Short-term yield differentials are anticipated to favor USD, but the long-term yield differential favors AUD, with the 10-year yield difference already over 40 basis points. However, if the RBA does decide to reverse course, the AUD may appreciate in the near run.

The Australian dollar's performance in the second quarter looks to be highly dependent on two important aspects. The Ukraine war's impact on commodity prices and the RBA and Fed's policy adjustments.

If the battle is prolonged, commodities prices appear likely to remain elevated for an extended period of time. While it is likely that worst-case scenarios have already been priced into the commodity market, the full impact of sanctions on Russia is unknown.

The RBA may begin its rate hike cycle sooner than expected, but the Fed is committed to a more aggressive approach to inflation. The latter's actions have already resulted in the steepening of the yield curve's rear end. However, increased RBA rate hike expectations have benefited the AUD, as Australian bonds have outperformed US bonds in terms of yield.

AUD/USD vs. Australia-United States Ten-Year Spread