We believe that global diversification should be at the core of each investor’s strategy. A globally diversified portfolio is likely to be better positioned to weather large movements in markets, and provide a more stable set of returns over time. However, one of the implications of a globally diversified portfolio is that currency fluctuations can have an impact on investment returns – both positively and negatively, depending on which direction currencies are moving. As such, an important question for investors is whether they want to take this risk, or if currency risk is something they should consider hedging.

In this article, we ask whether an investor should consider hedging currency risk at all, and look at the key drivers of the Australian dollar in the months ahead.

Where to from here - a bias to the downside?

Currency markets are notoriously volatile and hard to predict. This is because there’s a wide range of factors that can influence their performance. In predicting what the future has in store for the Australian dollar, we believe there are five key factors that investors should consider – all of which are likely to have a negative impact on the Australian dollar.

1. A divergence in central bank monetary policy

Although the Reserve Bank of Australia (RBA) is expected to keep interest rates on hold well into 2018, many other central banks have begun to turn ‘hawkish’. The US Federal Reserve (Fed) and the Bank of Canada have already raised interest rates, while the Bank of England looks set to hike by the end of the year. In addition, the Fed has announced a passive unwind of its quantitative easing (QE) program, and the European Central Bank is highly likely to announce tapering of its QE program in the coming months. This divergence in monetary policy is expected to weigh on the Australian dollar over the near term, but only marginally. This is because other central banks are expected to be conservative with their hiking strategy, and currency markets will quickly look to price any RBA rate hikes in H2 2018.

2. A shrinking Australia-US interest rate differential

The Australian 10-year bond yield is currently 2.85%, which is 50 basis points (bps) higher than the yield on US 10-year bonds. This makes Australian bonds very attractive for global institutional investors, who need to buy Australian dollar to purchase these bonds. This has been a major factor supporting the currency in recent years. However, the Australian-US interest rate differential is expected to shrink given the hiking path of the Fed. In fact, Commonwealth Bank of Australia (CBA) forecasts the differential will turn negative late next year. The last time the yield differential approached zero (it reached 15 bps in March 2001), the Australian dollar fell below USD 0.50.

3. A softer iron ore price

The iron ore price has been very volatile in recent years, and there is little to suggest the future will be any different. Although it’s difficult to forecast, both of our key research providers, UBS Research (UBS) and CBA, think iron ore prices will fall this year and next. UBS forecasts a price of USD 54/tonne 62% cfr by the end of 2018, while CBA forecasts a price of USD 45/tonne. If they are correct, a softer iron ore price should weigh on the Australian dollar over the next 18 months, as it will impact demand for dollars, our trade deficit and hence our current account.

4. A widening current account deficit

Over the past three months, Australia’s current account has been improving due to higher export prices and volume and this has been a major reason for the recent appreciation of the currency. However, recent data shows that the current account deficit is widening once again. If this trend continues, it may not have the same positive influence on the currency that it has had in recent months.

5. The possibility of US fiscal reform

When looking at exchange rates, factors which influence the counterpart currency also need to be taken into consideration. At present, the delay in US tax reform and fiscal spending is weighing heavily on the US dollar, which is seeing almost all currencies, including the Australia dollar, strengthen versus the US dollar. Going forward, US political uncertainty is likely to continue weighing on the US dollar, but given it is already 10% off its recent high, I can be argued that much of this discal pessimism has already been priced in. If this is the case, the future impact of any uncertainty will be much less than in the past. Conversely, if the US can implement fiscal reform, it is expected to be a major positive for the UIS dollar, and detractor for other currencies.

At present, with the Australian dollar hovering around USD 0.80, we think that it's near the top ot is forecast band for at least the next six months. There is, therefore, little incentive to hedge at current levels. If the Australian dollar trades below USD 0.70, then it is a much more pertinent question that needs to be answered, and we would generally say that at this level, hedging would be recommended - especially if it falls below USD 0.65.

You can read our full analysis here, where we discuss how far the currency could move, and whether hedging currency risk is worthwhile.

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