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This evening, the Reserve Bank of Australia will be faced with a very difficult monetary policy decision. So far, they have raised interest rates two months in a row by 25bp each time. At this point, there is a fifty-fifty chance that the central bank will raise interest rates to 3.75 percent. Although the tone of the minutes from their November meeting suggests that they could take a break from hiking rates, the latest comments from RBA deputy governor Battelino suggests otherwise. There is no question that the central bank intends to continue to raise interest rates, but they may choose to not do so in December to avoid being criticized for spoiling Christmas. Their decision on interest rates and their reasoning could determine the fate of the Australian dollar for weeks to come.

Since the beginning of the year, the Australian dollar has been on a tear. It appreciated more than 30 percent against the U.S. dollar and even came close to hitting a 16 month high in the process. The primary reason why the Aussie outperformed every other currency is because Australia is the only G20 country raising interest rates at this time. However in order for the Aussie to resume its uptrend, the Reserve Bank has to continue raising interest rates. On December 1st, the Reserve Bank will make this year’s final monetary policy announcement and investors are divided on whether or not the RBA will raise interest rates for the third month in a row.

Gradual Lessening vs. New Upswing

In November, the RBA raised interest rates for the second time this year to 3.5 percent. At that time, the Australian dollar actually fell on the heels of the announcement because the RBA failed to not hike by 50bp, talked about the dampening effects of a strong currency and indicated that they will “gradually lessen” monetary policy. Although the central bank plans on bringing interest rates to neutral levels, RBA watchers immediately latched onto the words and interpreted them to mean that the RBA could pause in December. However less than 2 weeks ago RBA deputy governor Battelino said the Australian economy “only recently entered a new upswing” and that “it is reasonable to assume that we will see this growth extended for a few more years.” Since the beginning of the year, the global economy has stabilized significantly and the Australian economy is growing but recently, the pace of the rebound has slowed. Therefore the timing of Battelino’s comments is particularly noteworthy and suggests the RBA may believe that the economy and Australian consumers could easily handle another rate hike. The following table shows how the economy has changed since the last monetary policy meeting.

Why the RBA Could Hike Rates in December

Fundamentally there are many reasons why the Reserve Bank should continue to raise interest rates. The most important being the labor market. If you look across the globe, the one overwhelming problem that everyone is facing is increasing unemployment. However, Australia has been the exception in that the country experienced positive job growth 3 out of the past 4 months. In October, a net of 24,500 Australians found new work while 190k Americans lost their jobs. Housing demand remains very strong with home loans jumping 5.1 percent in September as the government’s stimulus program attracts first time home buyers. Businesses are also handling the rate hikes well. The latest figures indicate that confidence rebounded towards its 6 year highs. Given that interest rates are still at emergency levels, the RBA intends to bring their rate back to neutral which is estimated to be between 4.25 to 5 percent.

Why the RBA Could Pause in December

Yet, the primary reason why the RBA could pause in December is perception. There is a lot of stigma and criticism that can come with raising rates before the holidays. The last time the RBA tightened monetary policy in December was 6 years ago and since 1990, the RBA has never raised interest rates three months in a row. Although the Australian economy is outperforming all of the other major economies, there are still pockets of weakness. The latest retail sales numbers revealed that consumers cut back in September despite the improvements in the labor market. Inflationary pressures are also under control so there is no need to rush. By raising rates in December, the RBA could dampen holiday spending because consumers, particularly those that recently bought new homes are extremely sensitive to rate hikes. They may also not want to appear overly aggressive.

What does it mean for AUD/USD?

The futures market is currently in pricing an 80 percent chance of a rate hike in December. If the Reserve Bank follows through with additional tightening, it should help propel the Australian dollar towards parity because it reflects their conviction towards normalizing monetary policy. A pause on the other hand could trigger a temporary correction in the AUD/USD and the degree of correction will be contingent upon what the RBA says because if they still plan on hiking rates in the first quarter, the dip may be nominal. As long as the economy remains resilient in the face of additional rate hikes and barring fresh concern about Dubai, the Australian dollar should continue to outperform. It is important for traders to look at the big picture and think about the long term trajectory of interest rates because the RBA may simply pause to avoid being called Grinch who stole Christmas.

About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.