Reserve Bank Cuts Rate; Australian Dollar Set for Further Weakness

NEW YORK ( TheStreet) -- At its May monetary policy meeting, the Reserve Bank of Australia (RBA) lowered its benchmark interest rate by 25 basis points, to 2.75%. This is a new record low for the central bank.

The statement accompanying the decision showed the rate cut came as a result of concerns for the macroeconomic picture in Australia, and as an attempt to speed up the sluggish pace of recovery.

Specifically, the RBA cited elevated currency values as being particularly problematic, limiting export and manufacturing prospects and contributing to rising unemployment on a national level.

Comments from RBA Governor Glenn Stevens essentially suggested that elevated values in the Australian dollar are not an accurate reflection of the underlying fundamentals, with export prices in the commodities sector showing weakness and interest rates already low by historical standards.

The May rate reduction was the seventh cut in the last 19 months and was expected by roughly half the market. With consumer inflation at moderate levels, mining spending topping out and credit growth holding at subdued levels, the RBA still has room to ease its monetary policy if prolonged declines are seen in broader growth rates.

Currently, interbank cash-rate futures show that traders are betting the RBA will leave rates on hold at its June meeting before cutting the benchmark at least once more in the third quarter. Futures contracts indicate there is a 68% chance of a "no change" rate decision at the June 4 RBA meeting, while the September futures show the rate will be 2.5% after the summer.

Causes for Concern

Rate reductions are supportive for stock values and the Australian benchmark S&P/ASX 200 is trading back near its yearly highs after the announcement. The reverse is true for currency values, however, and the Australian dollar is now trading back near its yearly lows against its U.S. counterpart. This activity is reflected in ETFs such as the CurrencyShares Australian Dollar Trust ( FXA), which is already trading at its lowest levels since last October. The inability of markets to find buyers at these yearly lows suggests that the next downside target is parity with the U.S. dollar, a valuation level that has not been breached in the last 10 months.

To gain some perspective of what these valuations mean, it is important to look at historical averages. Between 1990 and 2006, Australia's currency didn't rise above 85 U.S. cents, but the aussie hasn't fallen back below that level in nearly three years.

Before its Sept. 14 elections, the Australian government will release its final budget before elections proposals. The budget is expected to show due a deficit of A$14.5 billion for the fiscal year. To account for this shortfall, the government cites the elevated strength of the Australian dollar, as it constricts prices and corporate profits, thus limiting overall tax revenue.

The Australia's economy is driven largely by its resource investment boom, with commodities demand from developing countries such as China playing significant roles as primary export destinations. Increases in currency values make exports more expensive for foreign customers, so it is clearly in Australia's best interest to enact policy measures that help return the aussie to its historical averages.

Downward Valuation Prospects

All of these factors combined suggest continued weakness for the Australian dollar in the near-term view. Interest rates in Australia are still well above what is seen in the other G7 economies, so there is still scope for the RBA to make monetary policy more accommodative in order to limit the negative effects an elevated currency is having on macro growth data.

While positive for the stock markets in the region, these factors will put downside pressure on the Australian currency, likely sending it to new lows before the end of 2013.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Cox is a university teacher in international trade and finance. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies and commodities). Trade ideas are generally based on time horizons of one to six months.

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