Article written by LGT Crestone Head of Public Markets Todd Hoare. Published in The Australian Financial Review Tuesday October 29, 2024.
Investors may want to consider increasing exposure to Australian dollar-denominated assets or reviewing hedging strategies that benefit from a stronger currency.
A few weeks ago the Australian dollar was at its strongest levels relative to the US dollar in over 18 months – almost US70¢.
A bout of stronger-than-expected US economic data (non-farm payrolls, unemployment, and retail sales) has since seen the Australian dollar fall to approximately 66.5¢. The question for investors is, where to next for the local currency?\
This question carries real implications for portfolios, as currency movements can impact returns and drive the need for hedging strategies.
With US and global interest rates set to fall below Australian rates, investors may want to consider increasing exposure to AUD-denominated assets or reviewing hedging strategies that benefit from a stronger Aussie dollar.
Several economic forces that once weighed on the AUD now seem to be shifting in its favour, potentially driving further strength – or at least easing some of the downward pressure.
Central to these forces are global interest rate differentials, specifically the difference between Australian interest rates and those in the US, Europe, and Japan.
Over the past 16 months, the Federal Reserve has raised rates from near zero to 5.5 per cent. While the Reserve Bank of Australia increased rates at a similar pace initially, it has been less aggressive, leaving US rates about 1 per cent higher than Australia’s through 2023 and much of 2024.
Now, the tide is turning. The competitive interest rates that have been on offer in the US, Europe, Canada, and the UK are starting to reverse, as these major central banks are expected to drop sooner – and more sharply – than in Australia.
If market pricing holds, global central banks are set to cut rates much more aggressively than the RBA over the next year – by about 130bps in the UK and 140bps in the US, compared to just 70bps forecast from the RBA.
This means US interest rates, which have been higher than Australia’s, are expected to fall about 0.25 per cent below Australian rates by the end of 2025.
European rates could drop 180bps below the RBA cash rate (currently 110bps), while UK rates are forecast to align with Australian rates from their current 65bps premium. All else being equal, this shift should boost demand for the AUD.
The AUD is seen as a “risk currency”, rising when global markets are optimistic and falling when sentiment sours. This relationship makes the AUD particularly sensitive to movements in equity markets and commodity prices. For example, when global stock markets perform well – like they have recently – the AUD usually follows suit.
In fact, the Australian dollar-US dollar pair is highly sensitive to equity-related risk sentiment, and with global equity markets reaching all-time highs, it’s no surprise that the AUD is strengthening.
Over the past decade, the AUD-USD has exhibited the strongest correlation with the MSCI All Country World Index among major currency pairs.
Notably, since 2006, whenever the MSCI Emerging Market Index has risen in a calendar year, the Trade Weighted Australian Dollar has appreciated as well.
This strong correlation indicates that as investor confidence rises and equity markets strengthen, the AUD is likely to benefit, highlighting the importance of monitoring global market trends for those holding AUD-denominated assets.
As a resource-dependent economy, Australia relies heavily on exports like iron ore and coal.
The sharp decline in growth expectations for China – particularly in the commodity-intensive sectors like property and infrastructure – has weighed on demand for the AUD.
Until now, most currency forecasters had factored in little upside for the AUD from stronger Chinese developments. Instead, they focused on Australia’s rate resilience, driven by relatively high inflation and recent fiscal measures.
Any strength predicted for the AUD was primarily based on expectations of a weaker USD rather than optimism about the AUD itself.
Consequently, the surprise announcement towards the end of September from Chinese authorities around a stimulus package aimed at supporting property and capital markets represents a notable upside surprise.
While follow-up fiscal measures are needed to solidify this shift, the improved sentiment towards China’s short-term prospects is positive for the AUD, especially given the bearish market outlook.
While the fundamental story leans positive, there are (as ever) downside risks to watch for, given the AUD’s risk-on nature.
The looming US Presidential election remains too close to call, while tensions in the Middle East are continuing to ratchet higher.
Either or both could catalyse increased volatility in equity and currency markets and weigh on the AUD.
That said, in a well-diversified multi-asset portfolio, a weaker AUD can be a valuable source of downside risk protection.
However, the policy initiatives announced by Chinese authorities are the strongest indication yet that they have reached the limit of their tolerance for gradually unwinding excesses built up over the past decade.
While investors will debate whether these measures will flow through to the real economy and trigger a recovery, the assumption that the AUD cannot sustain a rally under weak Chinese growth – reflected in soft iron ore prices – is now up for reconsideration.
Just as we’ve seen with the Japanese Yen’s rapid reversal, when a dominant market narrative is challenged, the resulting shift can be more dramatic than expected.
Bloomberg’s median forecast for the AUD sits at just 71¢ for the end of 2025 and 2026. However, technical analysts will note that the AUD has already broken out of the downtrend channel that’s been in place since 2021.
With rising optimism around a global soft landing, the dynamics that have kept the AUD below 70¢ for much of the past few years may now be shifting in its favour.
