What's the outlook for the AUD in 2017?

April 2017

What's the outlook for the AUD in 2017?

Following Citi's recent upgrade of its 6 to 12 month forecast for the AUD-USD rate to 75 US cents, we asked Investment Strategist, Simson Sanaphay, for his take on currency markets in 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:

1. The AUD is a commodity currency – our biggest exports are still iron and coal. The high price of bulk commodities improves our trade terms and relative strength.

2. As our major trading partners are China, India, Japan, South Korea, the AUD is an Asia Emerging Market proxy currency, meaning investors wishing to monetize Asia’s economic performance use the AUD as a liquid proxy.

3. Thanks to our AAA sovereign rating and yields, currently the second highest among G10 nations, the AUD is a carry trade beneficiary currency – 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. Higher iron ore and coal prices, plus China’s surprising pick up, could drive a higher AUD - but this forecast is still relatively moderate.

With the RBA likely to maintain a neutral stance as the Australian economy faces a highly indebted household sector, the 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 is looking to raise interest rates, and markets are anticipating greater fiscal stimulus from the Trump administration – all factors which are likely to result in stronger US growth, yields and long term economic performance.

The divergence between Australian and US central bank monetary policy will potentially move in favour of the US, so over the long term we remain 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.

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 a higher interest rate and all other things constant, it provides a better return – and this is reflected in stronger demand for the relevant currency.

In Australia, anaemic 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 is expected to raise cash rates from March, with markets pricing in up to two additional rises for 2017. This will make the AUD less attractive in comparison, especially if currency volatility could negate yield differentials that the AUD benefits from.

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 27% 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 compounded to drive a weaker AUD.

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

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 2.8%. 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.

We're 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 higher US coupons (particularly for US-denominated floating rate notes) and driving the strength of the USD.

If you're considering new investment opportunities, Citibank 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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