Is the Australian dollar headed for more downside?

AMP Capital chief economist Shane Oliver says he expects the Australian dollar ($A) to weaken further – making unhedged offshore investments more attractive — as interest rates continue to rise in the US. However solid commodity prices should put a floor under falls.

So far this year the $A has fallen from around US$0.80 to around US$0.72. “I think the likelihood is it’s got more downside,” Oliver says.

He notes that there are two conflicting processes at work.

The “dominant” force at the moment is the US Central Bank, the Federal Reserve, which has been steadily raising interest rates – 25 basis points every three months. The next interest rate decision is in September. But at the same time Australia’s central bank, the Reserve Bank (RBA), has kept rates on hold for several years and is likely to remain doing so for some time to come.

“The result is that the interest rate differential between the US and Australia has gone strongly in favour of the US dollar and is attracting money into the US economy,” Oliver says. “Cash is being parked there as opposed to be parked in Australia. So that’s a big negative for the $A.”

The interest rate differential is the difference between official interest rates in countries. The RBA’s official cash rate sits at 1.5%. The current federal funds rate target is 1.75% to 2%.

“We think that [interest rate differential] has got a lot further to go because we expect the Fed will continue those rate hikes going into 2019 at least. But the RBA is leaving interest rates on hold through 2019, at least. So that interest rate differential will get wider, pushing the $A down probably to around US$0.70.”

Oliver says the other force impacting the $A is commodity prices. He notes that bulk commodity prices are solid with iron ore around US$65-70 a tonne recently and coal prices are strong. “That’s providing a degree of support for the $A.”

Oliver says that these strong commodity prices are probably going to provide a “bit of a floor” of around US$0.68 to US$0.69 “rather than pushing it [the $A] higher.”

But he says there are other risks. “If this trade war [between the US and China] gets worse, then that could turn into a negative as commodity prices come under pressure.” Similarly, the turmoil in some emerging markets led by Turkey is also creating uncertainty for global growth and adding to downwards pressure on the $A.

“The bottom line is, investors should expect more downside for the $A. That enhances the value of offshore investments which are unhedged. But I don’t see a crash in the $A unless commodity prices take a big hit.”

As the recent fall in the $A on the back of the Turkish crisis highlights, being short the Australian dollar and long (unhedged) foreign exchange (particularly the $US and Yen) could work in certain cases as a hedge against threats to the global outlook.

By Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP CapitalSydney, Australia


Important notes


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