The Australian dollar’s (A$) relationship with the US$ has moved in broad ranging cycles over the long-term.
While the trend level of the A$ over the last 30 years is around 74-75c, the exchange rate has ranged from just under 50c at the height of the US tech boom in 2000 to over $1.05 at the height of the China driven commodity boom in 2011.
While the A$/US$ exchange rate does appear to have a mean-reverting tendency, the long wave volatility of the relationship can have considerable impacts on the international component of investment portfolios. As a result, we believe at least some partial hedging is prudent when the A$ moves well away from its long-term trend.
With the A$ currently sitting just above 68c, we have a partial 35-40% hedge recommendation for international equity portfolios.
The Two Key Drivers of the A$
The 2 primary factors that appear to explain most of the variability in the A$/US$ exchange rate are commodity prices and interest rate differentials.
The commodity price influence historically stems from Australia’s place in the global market as a small open economy with a heavy trading reliance on the commodity cycle. Interest rate differentials are an important driver of most currencies given the increasing dominance of global financial flows seeking the highest short-term return.
In addition to these 2 dominant factors, the A$ can come under pressure in significant “risk-off” periods for financial assets, such as the GFC in 2008 and the Covid-driven market dislocation of 2020. In large part, this reflects the safe haven role of the US$ in times of market stress relative to the A$ pro-cyclical nature.
Rate Differentials in the Driver’s Seat
It is interesting that, in recent years, the A$ looks to have decoupled somewhat from the (high) level of commodity prices and has been more influenced by the interest rate differential factor.
This has had the effect of pushing the A$ below its long-term trend level as US short-term interest rates have pushed well above Australian levels. It has also seen the A$ undershoot the Reserve Bank of Australia’s (RBA) preferred 2-factor regression model of fair value based on commodity prices and interest differentials (our 2-factor model currently suggests a fair value of 76c).
Looking at the trend in interest rate differentials over the longer term, Australia appears to have lost its traditional interest rate premium to the US, perhaps permanently.
This was a development that became evident in the pre-Covid period around 2018 when the Fed was tightening monetary policy in a unilateral fashion, which saw the US$ strengthen against the A$ as well as against a broader basket of currencies.
After global interest rates converged to effectively zero during the Covid dislocation, the US rate premium has re-emerged as the Fed has lifted rates at a much faster pace than the RBA.
This has weighed on the A$ relative to the US$ since the tightening cycle kicked off in the second quarter of 2022.
The A$ to US$ interest rate spread appears to have peaked around March this year. Some partial closing of the differential in recent months has helped the A$ lift from its cyclical lows, although the spread continues to be relatively volatile as policy rate expectations ebb and flow.
The importance of interest rate spreads in influencing exchange rates is also emphasized by the renewed strength in other key currencies in recent months, such as the Euro and the British Pound. Expectations for rate increases have risen significantly, driving a strengthening in these currencies, relative to both the US$ and the A$.
At the other end of the spectrum, the Japanese Yen remains relatively weak with interest rates still anchored at zero, although even the Yen looks to be marking out a bottom against the US$, with expectations for a shift in policy being pondered.
Where to from Here for the A$?
Our view that the A$ has upside over the next year or two is based on 3 considerations: (1) The A$ is trading around 10% below its long-term trend level; (2) the A$ is trading just over 10% below our 2-factor regression model based on commodity prices and rate differentials; and (3) our expectations that the dominant driver of currencies in the current regime, interest rate differentials, should continue to move back in Australia’s favor over the next 12 - 18 months. That is, we expect the Fed is more likely to cut rates more quickly and by a greater magnitude over the next 12 - 18 months relative to the RBA, where rate cuts are likely to be later and more modest, at least initially. Our longer-term expectation is that neutral rates in the US and Australia should settle around the same level - i.e., ~3%.
Risks to our View
Apart from the risk that the expected closure in short-term rate differentials does not materialize, the other key risk to our constructive A$ view is the potential for a significant risk-off phase in financial assets. This would increase demand for the US$ as a safe haven asset. However, this is not our base case, with a US hard landing looking less likely and the banking system looking relatively sound.
Investment Implications
In summary, while a less aggressive tightening cycle over the last year or so has weighed on the A$, we see the ingredients for a shift in the interest rate momentum over the coming year to bring back support for the A$. As a result, we recommend sticking with some partial hedging of global equity portfolios. Additional generalised weakness in the US$ should, all things equal, support renewed interest in emerging market equities.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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