The Australian dollar (AUD) drifted lower throughout March from an intraday high of 1.0856 on 29 February to close at 1.0346, very close to the low of 1.0305 against the US dollar (USD). The USD saw continued strength against G10 and emerging market (EM) currencies during the period but fading sentiment towards the Chinese economy also exerted pressure on the AUD.

The month-end saw policymakers on both sides of the Pacific at the centre of attention. The Reserve Bank of Australia (RBA) held interest rates firm at 4.25% in April but the accompanying dovish statement was interpreted by the market as paving the way for a lower exchange rate. The Board point to a future decline in interest rates if inflation numbers are released at the end of April and suggest that price levels may remain stable within the target range of 2%-3%. The reason for the move was that output was weaker than the Board had anticipated. The AUD immediately sold off and the market began to price a 0.25% reduction in the overnight rate in May, followed by a further 0.75% before the end of the year.

The RBA statement was followed by the release of the minutes of the Federal Open Market Committee (FOMC), the committee that sets Federal Reserve monetary policy in the US. The minutes revealed that the widely anticipated third round of quantitative easing was far from imminent, although the Committee did not wish to rule it out altogether. Since quantitative easing essentially increases the supply of dollars in circulation, the indication of tighter supply led to a sharp increase in USD exchange rates. As a result the AUD began trading at levels below 1.0300 versus the USD.

The currency will remain sensitive to weaker-than-expected Chinese data and any material escalation in the European sovereign debt crisis. The Citi base case scenario is, however, that Chinese growth will slow but that the economy will not experience a hard landing and, for the moment at least, the worst outcomes of the European crisis appear to have been averted. As a consequence, Citi economists view the market's expectations of a 1% reduction in the RBA overnight rate before year-end as exaggerated. Citi expects the rate to be reduced by 0.25% and to remain at 4% until the end of the year.

Given the steady outlook for interest rates, Citi views an exchange rate at below 1.03 as closer to fair value. We recently revised our target forecasts to 1.05 for the second quarter of 2012 (from 1.08), to 1.03 for the third quarter (from 1.05) and to 1.01 for the fourth quarter of the year (from 1.02).