The Australian Dollar (A$) has been under renewed pressure since late September, as the prospect, and then reality, of another Trump presidency has joined a hawkish pivot by the US Fed to drive a surge in the US dollar.
These US-centric drivers reinforce the sense that the weakness in the A$ is more of a US dollar strength story than a case of specific weakness related to the A$. Indeed, the A$ is generally only slightly down against most of the other major exchange rate crosses in recent months (we are up against the New Zealand dollar!).
As a result, we see these US drivers as likely holding the key to where the A$/US$ rate goes over the coming year or so, despite our view that the A$ is fundamentally undervalued on a long-term basis.
Since early October, markets began to price in the rising probability of Trump’s return to the US presidency. By early November this became a reality, lifting the US dollar significantly. Trump’s policy platform has been widely perceived as bullish for the US dollar from a number of perspectives, at least for now.
Trump’s broad promise of tax cuts and deregulation are expected to boost US productivity, and hence US growth potential, although the exact magnitude of the boost remains highly uncertain. Nevertheless, this pro-growth sentiment has appeared to help boost the US$ in recent months.
Tax cuts are likely to add to the US budget deficit, and all things held equal result in higher US interest rates. Perhaps perversely, the market’s expectation is that this should attract capital to the US, thereby boosting the currency. Of course, this assumes the US deficit does not reach a point of “unsustainability”.
For now, the market appears content to fund the US deficit with only a modest increase in the bond market term premium, while the US currency remains very well supported. Arguably, the unique role of the US dollar in the world monetary system as the global reserve currency gives the US the capacity to run large deficits without significant penalty, albeit the strength of gold (we continue to hold a position in physical gold) and bitcoin suggest investors (and central banks) are quietly placing some long-term hedges.
Trump’s tariff policy pledge has also been perceived as US dollar bullish. The logic appears to be that tariffs will hurt the more export-dependent economies of Europe and Asia, relative to the less export-dependent US economy. Of course, a key question is how much of the tariff burden falls on US consumers? Tariffs (if broad) could turn out to be a significant drag on the US economy’s key growth engine - the US consumer. But for now, the market has interpreted Trump’s tariff pledge as dollar bullish.
Another Fed Pivot Has Also Been a Factor
The other key and perhaps more conventional driver of the recent strength in the US dollar is a fairly significant shift in rate expectations for the US Federal Reserve. The Fed cut rates in mid-December to 4.25-4.5%, however at the same time the Fed signalled less cuts than previously expected through 2025. The market is now fully pricing only one more Fed cut in 2025. This has been due to a combination of stronger-than-expected US growth and stickier-than-expected inflation. This has, alongside Trump’s policy pledges, also helped to push the US$ higher. A relatively attractive interest rate differential has indeed been an important driver of US$ strength for a number of years now.
Apart from the structural tendency toward strength (over the last 10 years) stemming from a US interest rate premium, cyclical variations in the US dollar have been quite closely linked to shifting perceptions of US economic momentum and the path of Fed policy rates. Evidence of a strong US economy has led to expectations for less Fed easing and a stronger dollar. In contrast, data suggesting a weakening economy has brought back expectations for more Fed cutting and delivered a weaker dollar. We think this economic data flow will continue to drive volatility in the US$/A$ exchange rate alongside Trump’s policy announcements, although the likely data trend over the next few months is not particularly clear, particularly with last week’s outsized US inflation print.
While we see the US economy and US dollar for the most part being in the driver’s seat, Australia’s own central bank expectations have also influenced the performance for the A$ at the margin. In recent months, as expectations for Fed cuts have faded, and conviction that the RBA will cut rates multiple times in 2025 has grown. As a result, the interest rate gap between Australia and the US is expected to deteriorate again. This is after cash rates have basically converged to the same level (~4.35).
Expectations are currently that the RBA cuts three times in 2025, while the Fed cuts only once. Hence, the forward curve is once again moving in favour of the US. A premium is also evident for the US, as we move further out the interest rate curve.
This shows that historically the A$ goes up when the Australian interest rates rise versus US rates and vice versa. Of course, expectations could shift again over the coming year, but for now forward interest rate differentials favour the US.
Is the Weak A$ an Inflation Threat?
There has been some commentary in respect of the weak A$ being inflationary. However we don’t think the RBA would be overly worried at this stage. The A$ has fallen roughly 10% from September 30th against the $US. Most other countries’ currencies have also had sharp falls against the $US, so the value of the A$ on a trade weighted basis is only down by around 5% over the same period. This is neither here nor there in terms of the impact on inflation. On a trade-weighted basis, the A$ is in basically the same range it’s been in for the last four years now. Consequently, at this stage we still see significant potential for multiple cuts from the RBA in 2025.
Where to from here for the Aussie?
From a long-term perspective the A$ appears cheap. A potential guide to the A$ long term centre of gravity is what is called purchasing power parity (PPP). According to PPP, exchange rates should equalise the price of a basket of goods and services across countries. If, over time, Australian prices and costs rise relative to the US, then the value of the A$ should fall to maintain its real purchasing power, and vice versa if Australian prices fall versus the US. Consistent with this, the A$ tends to move in line with relative price differentials over the long-term. Right now, the A$ looks cheap at around $US0.63 compared to fair value of around $US0.70-0.72 on a purchasing power parity basis. This is also not too far from the Australian dollar’s simple long-term average level (~0.75c). The A$/US$ does appear to have a long-term mean reverting trend, despite its ability to depart from this equilibrium for extended periods.
The A$ also continues to look “cheap” versus Australia’s trade-weighted commodity basket. This has traditionally been quite an important driver for the currency. Although its importance seems to have declined in recent years, with interest rate differentials gaining prominence. Perhaps the market is expressing a view that the structural outlook for Chinese commodity demand is deteriorating, despite what are still very solid spot commodity prices for Australia’s trade weighted basket. However, it is possible that commodity strength brings back focus on Australia’s strong terms of trade position at some point in the future. A big China stimulus push is a potential catalyst in this respect, and was in part behind the A$ push to over 69 cents in September.
Finally, from a tactical perspective, sentiment towards the A$ is quite negative, reflected in short or underweight positions. Many of those speculators who want to sell the A$ may have already done so and an “optimistic” US dollar bull case from Trump’s polices may already be factored in. This leaves the A$ open to a rally if there is any “good” news.
This could conceivably come from a more benign-than-feared tariff outcome, a loss of momentum in the US economy relative to Australia, or a large China stimulus announcement.
Over the next 12 months, the A$ is likely to be buffeted between changing views as to how much the Fed will cut interest rates relative to the RBA and how far Trump goes on his tariff pledge. Our base case is the A$ is oversold, but our tactical conviction is fairly low. We retain a modest amount of hedging on international equites portfolios. Longer term, the potential positives of undervaluation (based on both PPP and terms of trade) alongside negative sentiment suggest the A$ can ultimately move back toward 70c or a touch above.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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