Outlook for the Australian Dollar and impact of interest rate hikes

June 2017

Outlook for the Australian Dollar and impact of interest rate hikes

Citi reiterates its long term forecast for the AUD/USD of 72US cents, we asked Investment Strategist, Simson Sanaphay, for this take on the “Aussie” in the second half of 2017.

Q. What are the key drivers of the AUD?

A. There are three key factors that influence the long-term value of the AUD:

That clampdown really took effect from about the start of the year, so that now foreign buyers only account for about 5 per cent of investment properties bought compared to 15-20 per cent this time last year.

  1. The AUD is a commodity currency, as our biggest exports are still iron and coal. The AUD and terms of trade will strengthen or weaken, depending on the direction of commodity prices.
  2. As our major trading partners are China, India, Japan and South Korea, the AUD is viewed as an Asia Emerging Market proxy currency. That means investors use the AUD as a bet on Asia’s economic performance.
  3. And thanks to our AAA sovereign rating the AUD is a safe, low-risk destination for investors seeking returns in Australian Government Bonds.

Q. What are Citi’s short and long term forecasts for the AUD?

A. Iron ore prices have fallen having peaked earlier in the year, this has weighed on the AUD. We continue to expect the iron ore market to face further oversupply with production expansion coming from Australia, Brazil and India.

With the RBA likely to maintain a neutral stance as the Australian economy faces a highly indebted household sector, the other key driver behind the value of the AUD will be the monetary and fiscal policy outcomes of the US Federal Reserve and the Trump administration.

The US economy is approaching full-employment, the Federal Reserve has raised interest rates and looks to do more, in our view in 2017-18 The markets are anticipating greater fiscal stimulus from the Trump administration, including significant corporate tax cuts, tax simplification and infrastructure spending – all factors which are likely to result in stronger US growth, yields and long term economic performance.

It will create greater divergence between the Australian and US Central Bank monetary policy, which we expect to move in favour of the US, so over the long term we remain moderately bullish on the USD.

Of course the wild card is how the US administration guides the USD as a policy tool to “Make America Great Again”, as official comments on trading partner currency imbalances have created some uncertainty for a stronger USD.

With this uncertainty we expect AUD to trade in the mid-range of the technical support levels of 0.71c-0.78c in the short term, and head lower medium term as the interest rate differential between the two countries narrows.

Q. How does Australia’s low inflation/low interest rate economy affect the AUD performance to the USD?

A. Long-term currency performance is determined by yield differentials. If one economy offers higher interest rates and all other things constant, it provides a better return – and this is reflected in stronger demand for the relevant currency.

In Australia, anemic wage growth with high levels of underemployment is keeping inflation low and we predict the RBA will keep interest rates on hold – potentially to mid-2018. Conversely, the US Federal Reserve has already begun the process of normalising monetary policy, with markets pricing in up to two additional rises for 2017. This will make the AUD less attractive in comparison.

"Our clients are taking advantage of currency movements through their investment allocations."

Q. How do these currency movements’ impact investors?

A. Whether you realise or not, you invest with a local bias. You are likely to have a majority of investments in equity or fixed income denominated in your home currency – and that ties your investment portfolio performance to the fortunes of that currency.

Being in the ‘wrong’ currency can limit portfolio returns – while being in the ‘right’ currency can amplify or hedge investment returns.

As an example, the AUD has fallen 33% against the USD over the past five years, which impacts investors’ returns. Those with exposure to the mining and materials sectors felt the impact of the end of the commodities super cycle, plus the falling commodity prices that compounded to drive a weaker AUD.

Q. Do you suggest investors consider diversifying their currency holdings away from AUD?

A. You don’t need to be a currency trader to appreciate the opportunities and risks of currency movements for your investment portfolio over the long term. Investors should be thinking about the long-term prospects of a currency’s performance, rather than concentrating on short-term volatility.

We expect the global growth from 2016 to extend into 2017 with real GDP growth at 2.9%. As this is likely to be the result of divergent rates of economic growth within developed and emerging markets, investors should consider that currency movements which reflect this divergence can amplify or hinder their portfolio returns.

The AUD is likely to be hampered by a neutral RBA for quite some time – and there is the potential for further downside risks if our trading partners and/or our pace of economic growth slows.

Australia’s economy has been in a lengthy transition as non-mining businesses like education and tourism grows in share of Australia’s economic activity, a lower AUD is preferable for these industries so even though the RBA doesn’t target an exchange, its clear its preference is for a relatively lower AUD. A high AUD would “complicate the economy’s transition from mining”.

We’re also seeing our clients take advantage of increasing US yields by investing in US-denominated fixed income. As the US Federal Reserve increases rates, this has the combined effect of driving higher US coupons strength of the USD.

If you’re considering new investment opportunities, Citi can offer both AUD and USD denominated investments across our fixed income and structured investments which suit a range of risk profiles and investment goals. Or if you’re looking to diversify your currency holdings, we provide access to 10 currencies and a range of FX solutions. Talk to our team today to learn more.

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