Is now the time to consider currency hedging?

When I kicked off my career as a reporter covering the financial advice industry back in 2007, I remember how frustrated advisers (and their clients) were with the performance of international equities funds, which largely invested in the U.S.

“Never again,” an adviser grumbled to me, swearing off allocations to overseas companies.

“The rising Australian dollar killed my returns!”

And he had a point. From the early 2000s, the Aussie dollar surged from around 50 cents to above parity in the 2010s, wiping out returns for global funds.

But in hindsight, that painful period turned out to be the perfect time to load up on unhedged international equities. The subsequent fall in the AUD — now sitting around 65 cents — has been a powerful tailwind for local investors (less so for tourists).

In fact, Australian investors who bought an S&P 500 ETF a decade ago have enjoyed returns of around 14.3% p.a. thanks to the weaker AUD, compared to about 12.5% p.a. earned by local U.S. investors.

Now the question begs: are we due for a major reversal in the AUD/USD? And if so, is it time to implement currency hedging in portfolios?

To find out, I spoke with three experts:

1. Ashley Owen, Director of Owen Analytics, who has spent decades modelling long-term currency and market cycles.
2. Daniel Kelly, Chief Investment Officer at Viola Partners, responsible for managing the firm's multi-asset portfolios.
3. Shane Oliver, Head of Investment Strategy and Chief Economist at AMP Capital.

We’re not in a crisis — so what gives?

At just over 60 cents, the AUD/USD is trading near levels it has only hit during major global shocks — the early 2000s tech wreck, the GFC, and the COVID panic of 2020.

And yet, there’s no clear economic crisis today. In fact, Donald Trump’s trade war has raised doubts about U.S. exceptionalism and sparked renewed debate about “de-dollarisation”, a process whereby countries look to reduce reliance on the greenback for international trade.

Australia’s economy is relatively strong, and interest rates remain among the highest in the developed world. By that logic, the AUD should be much stronger.

But as the experts explain, currency movements aren’t just about local fundamentals. They reflect a complex push and pull between long-term drivers, cyclical forces, and short-term sentiment — all tugging in different directions.

The three drivers of the AUD/USD

“It’s fairly straightforward,” explains Owen.

“Long term, it’s inflation differentials. Medium term, it’s commodity price cycles and interest rate differentials. And in the short term, it’s share prices.”

Here’s how that plays out:

1. Long term: Inflation differentials

Over time, exchange rates tend to reflect the relative inflation levels of two economies. Since 1900, the Australian dollar - or the Australian pound until 1966 - has lost 74% of its value against the U.S. dollar, largely because Australia’s inflation rate averaged 1% higher than that of the U.S. for more than a century.

But since 2000 — after decades of wars, crises, devaluations, and the abandonment of currency pegs — inflation in both countries has converged. As a result, AUD/USD movements have narrowed relative to history, and the neutral exchange rate now sits in a range of 65 to 70 U.S. cents.

“Inflation ultimately determines the value of money over the long-term — the more inflation a country has, the less its currency is worth,” says Owen.

“Over time, inflation has compounded at a higher rate in Australia than in the U.S., so on that basis the Aussie has declined versus the greenback over time."

Kelly and Oliver agree that inflation and purchasing power parity (PPP) are key long-term drivers of currency value.

“Relative PPP looks at changes in price levels over time and suggests that the country with higher inflation should see its currency depreciate. On that basis, PPP puts the AUD/USD closer to 70 cents,” says Kelly.

Oliver’s modelling goes slightly further, placing fair value nearer to 73 cents. But to avoid splitting hairs, all three experts agree it’s broadly trading in line with fundamentals.

2. Medium term: Commodities and rates

Owen says the AUD/USD’s decline from $1.10 in 2011 to current levels has been “pretty much a straight China growth and commodities story."

The post-GFC boom in Chinese stimulus drove massive demand for Australian exports, sending commodity prices - and our dollar  - soaring. But as that demand waned, prices fell, and so did the Aussie.

Interest rate differentials also matter. Historically, Australian rates have averaged about 3% above U.S. rates since the dollar was floated in 1983 — which gave hedged investors a nice return kicker. But that’s changed.

“Right now, Aussie interest rates are above U.S. rates — so there’s a cost to hedging, which is very unusual,” says Owen.

Looking ahead, Owen sees the U.S. cutting rates more aggressively than Australia in the event of a slowdown — especially under Trump’s economic agenda. That could keep Australian interest rates relatively high and “put a floor under the AUD for a while.”

Oliver strikes a similar note.

“There are conflicting forces at play: Trump’s trade war could weaken China and hurt the AUD, but if the U.S. loses its shine globally, the USD could also come under pressure," he says.

3. Short term: The AUD as a ‘risk’ currency

In the short term, Owen describes the Aussie as a ‘risk’ currency — a proxy for China, commodities, and global growth sentiment.

“It falls when shares fall and rises when shares rise — 80% of the time or more,” he says.

Kelly adds that short-term moves are essentially unpredictable.

“In the short to medium term, currencies follow a random walk. There are too many moving parts — trade balances, interest rates, central banks — to make reliable short-term predictions," he says.

So, should you hedge?

Whether to hedge depends on the asset, your time horizon, and the role the investment plays in your portfolio.

“Your FX hedge ratio is probably the third biggest driver of portfolio returns,” says Owen, referring to how much of an investor’s international portfolio is AUD-hedged versus unhedged.

For growth assets like global equities, private equity, or infrastructure, Kelly leans toward staying unhedged.

"Hedging isn’t free, and it can be quite expensive to run over a very long period of time that can erode returns, so for assets such as US private equity, venture capital, or infrastructure, we will generally be happy to sit in an unhedged share class and in the native currency of those assets. There is an argument that you want the asset exposure and currency to match with growth-based investments. ," he says.

But for income-generating assets, such as global credit or private debt, he strongly prefers hedging.

“Imagine a U.S. private credit fund yielding 9%. If the currency moves against you by 6%, you’ve just wiped out most of the return,” explains Kelly.

"It’s important to never forget that Australian investors have to pay bills and their mortgage in Australian dollars, so what currency the cash flows are coming back in is important if they are going to be relied upon to pay for living expenses."

Owen, Kelly, and Oliver agree that if the AUD nears or falls below 60 cents, it could be a sensible time to gradually add hedged exposure. Owen points out that many advisers already adopt a 50/50 split between hedged and unhedged assets - but that doesn’t mean investors should rush to rebalance.

“You don’t want to be too active — there’s too much tax, too much transaction cost, and too much noise,” says Owen.

Final thoughts

The Aussie dollar might look weak, but over the long run, it’s trading close to fair value. That’s because Australia’s inflation has consistently run higher than the U.S., dragging the AUD/USD lower over time.

So, should you hedge? There’s no one-size-fits-all answer — but it can make sense in certain situations, like locking in predictable cashflows or when the currency hits extreme levels.

If you’re considering it, the next question is how. In a follow-up piece, I'll list out the products and strategies investors can use to manage FX risk.