Forex Investment and Currency Trading

Price action in AUD/USD has this week been dominated by the poor May employment data in Australia and a generally rampant USD. But more generally, markets have been dominated by central banks’ warnings on rising inflation expectations and almost unprecedented movements in short term interest rate expectations around the world. Recent days have seen warnings on the threat of rising inflation expectations from the Fed Chairman, Vice Chairman and at least five other Fed officials, the ECB President and no less than seven other ECB governing council members. As a consequence, short
term interest rate rates have priced in anything up to 50bp of additional central bank hikes over the coming year.

It is particularly pertinent then, that this week’s median inflation expectation in the Melbourne Institute’s June survey of consumers’ expectations jumped to a record (15 year) high of 5.9% from 5.2% previously. However, while the impact of rising inflation expectations on central bank policy is clear cut - earlier rate hikes or delayed cuts - the impact on currencies is much less obvious. Are spiking inflation expectations positive or negative for AUD?

Recent experience would suggest positive, but this may not always be the case. Inflation expectations are proxied by the spread between the longest liquid inflation linked government bonds and similar maturity conventionals. Rising inflation expectations in Australia relative to the US have almost always been associated AUD appreciation.

GBP’s recent performance, however, suggests some caution in expecting this relationship to hold indefinitely. In recent months, the relationship has been exactly the opposite of that in Australia. Sharply rising UK inflation expectations relative to the Eurozone have been associated with GBP weakness. Is AUD in danger of a similar reversal of fortunes where rising inflation expectations see the currency derated?

The answer probably lies in the growth/inflation mix, rather than inflation itself.  The notable feature of the UK markets recently is that inflation expectations have risen at the expense of real yield – often seen as a barometer of long term growth prospects. As a result the growth/inflation mix in the UK stands as particularly poor. In Australia this not the case – rising inflation expectations are
accompanied by still robust growth expectations. Market remains AUD bullish and await a technical signal to express this as short GBP/AUD position.