Frank Uhlenbruch

Following the latest move by the US Federal Reserve (Fed) to lift the Fed funds rate to between 2% and 2.25%, the spread between the US and Australian cash rates has inverted to levels not seen since the currency was floated back in December 1983.

Two drivers often used to gauge the direction of the Australian dollar are interest rate differentials with the US and commodity prices. Chart 1 illustrates the period in which the currency depreciated by 33% (January 2013 - September 2015), coinciding with a period where both the cash spread narrowed (the Reserve Bank of Australia (RBA) was easing while the Fed was on hold) and commodity prices fell.

Chart 1: Australian dollar drivers

Source: Bloomberg, RBA, US Federal Reserve September 2018 FOMC projections, Janus Henderson Investors. As at 8 October 2018. Note: SDR = Statutory Drawing Rights.

As markets are forward-looking, it is worth noting that the big falls in the Australian dollar all occurred before the Fed began its tightening cycle in December 2015. If we take the Fed’s dot plots, which point to 100 basis points (bps) of further tightening by the end of 2019, and our base case view of one RBA tightening by the end of 2019, the cash spread is set to invert to -138bps. This could take the spread into uncharted territory, pointing to a much lower currency. However, offsetting downward pressure from this source are two factors:

  1. Markets are supposed to discount future events, so much of this move may already be priced in; and
  2. Commodity prices have been holding at good levels.

Looking ahead, we see mild downward pressure on the Australian dollar as the Fed continues to tighten, but for falls to be limited by solid offshore growth.

Steps by Chinese authorities to boost their economy to offset the drag from higher US tariffs is having positive spillover effects on demand for Australian commodities. As we head into the second half of 2019, the Australian dollar should begin to find some support as markets begin to factor in RBA tightening, with the Fed close to the end of its current tightening cycle. By the end of 2019, we are looking for the Australian dollar to lift back up to 74 US cents.

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