Bets for Aussie weakness are on the rise, again

John Phillips | Digital Editor | CNBC

Just two days after notching a two-month high, the Australian dollar is under fresh attack as bets rise for the central bank to cut interest rates at its November meeting.

A decision by Westpac, one of Australia's top four banks by market capitalization, to increase home loan and residential investment property rates by 20 basis points on Wednesday was interpreted by traders as a sign that the Reserve Bank of Australia (RBA) will be forced to lower benchmark interest rates from their current 2 percent trough.

Higher mortgage rates could deal a blow to Australian consumers, especially if other banks follow suit in the near-term, as residents use more of their paychecks on mortgages than spending ahead of the all-important Christmas season.

"The market has clearly taken today's news as paving the way for the RBA to potentially cut rates... The market reaction clearly points to the risk that other banks are expected to follow suit," said Prashant Newnaha, an interest rate strategist at TD Securities.

Goldman Sachs is subscribing to that view. "Following the preemptive interest rate hike by Westpac, we now see the November rate cut as highly likely and a strong case for a further rate cut in early 2016 can now be made," economists said in a report.

Wednesday's news saw the Australian dollar hit an intra-day low of $0.7195, retreating further from Monday's two-month high of $0.7382. For nearly two weeks, the currency has enjoyed a relentless rally, with Monday marking the currency's third longest consecutive gain since floating in 1983, according to spread better IG. But gains were abruptly halted on Tuesday following China's larger-than-expected fall in September imports, which bodes ill for Australian exports.

To be sure, not everyone expects a rate cut as early as November.

"The RBA is not going knee-jerk react to today's news. Their modus operandi has been one of reactivity, not proactivity and so even if other banks follow with similar moves, I don't think the RBA will be in any state of mind to preempt that. Should it happen, they will react but it's nothing urgent in the near-term," Sally Auld, JP Morgan's head of fixed income and FX strategy, told CNBC.

Moreover, the RBA may have already anticipated banks lifting rates, Newnaha warned. Indeed, comments by Governor Stevens seems to suggest that. After the Australian Prudential Regulation Authority asked lenders to increase cash buffers in July, Stevens was quoted as saying "I imagine it will result in some rise in mortgage rates from the major banks. It is supposed to."

However, there is another major factor supporting the chances of November easing, Goldman Sachs noted.

"Fears of a severe drought are escalating... A key leading indicator (the Southern Oscillation Index) recently retreated to one of its five lowest readings in the past 150 years and is now well below the 8-point threshold, which is typically consistent with a drought."

Looking at historical evidence, significant droughts tend to strip anywhere between 50-100 basis points from gross domestic product (GDP) growth so that's likely to spur the RBA into action as risks to economic growth remain skewed to the downside, Goldman added, referring to factors like weak income growth.

Playing the Aussie

Stimulus expectations aside, there are a plethora of factors supporting extended currency weakness.

"Weaker commodity prices and a narrowing interest rate differential with the U.S. are a reliable combination to push the AUD lower. A third factor is the ugly trade deficit, which is driving deterioration in Australia's broader external balance," explained Bill Evans, chief economist at Westpac, who expects the currency to close out the year around 68 U.S. cents.

Moreover, heavy exposure to a slowing Chinese economy will remain a negative factor.

Economic pain in Australia almost over?

"Australia relies heavily on Chinese demand and the 20.4 percent drop in [Chinese September] imports, which was the largest decline in seven months, is alarming," explained Kathy Lien, managing director at BK Asset Management.

"While [recent] declines in AUD/USD puts only a small dent in the currency pair's recent rise, we believe that further losses are likely because the underlying foundation for Australia's economy is weak."

Australia's fundamentals are even more discouraging than fellow commodity producer and China-exposed neighbor New Zealand since the latter country at least has an upswing in dairy prices to aid its economic recovery, Lien added.

But there are still reasons that could dampen future weakness.

Rising bets for extended weakness in the Chinese yuan (CNY) and a slowing of the commodity rout could make it harder for the central bank (RBA) to jawbone the Aussie (A$) lower.

"The prospect of sustained CNY depreciation should make incremental A$ weakness harder to engineer, in view of the CNY's 28 percent weight in the trade-weighted A$. And the bulk of the decline in metal prices may already be behind us, leaving less room for rhetoric about the need for exchange rate adjustment to softer terms of trade," explained Konstantinos Venetis, economist at Lombard Street Research.

If the currency weakens too much, import inflation may become too pronounced for the RBA to ignore, thereby limiting the room for reducing rates in the event of a shock, he added.