Over the past several years the Australian dollar has depreciated sharply against many other currencies. By mid-March, the A$ was down almost 30% from it's 2011 peak against the US$, and down by almost 20% against a trade-weighted basket of currencies.
Our view on the Australian dollar outlook is based on the observation that the two biggest drivers since the GFC have been commodity prices and interest rate differentials. There is a clear correlation between the price of Australian commodity exports and the A$ (refer Figure 1). The price of key commodity exports including iron ore and coal, which together make up a third of total exports, have been declining broadly since 2011 as global supply has ramped up to meet demand from China. Commodity prices remain on the downside in 2015-16.
The other key driver for the Australia-US dollar exchange rate, is the interest rate differential between the two countries. Since 2008, Australia's official interest rate has fluctuated between 2.25% and 4.75%, and remained near zero in the US. This positive interest rate gap, along with Australia's AAA credit rating, has encouraged many buyers to invest in Australian fixed income assets. The interest rate gap has slowly narrowed as the RBA has cut rates since 2011, and it seems likely to close further given the expectation that the US Federal Reserve will start hiking rates later this year, and the RBA will cut rates. Depending on how much further the gap narrows, we could see further investment flows out of Australia, and a weakening of the currency.
Figure 1 – RBA Commodity Price Index vs AUD/USD Exchange Rate
Notes: The RBA Commoidity Price Index is a trade-weighted average of Australian commodity prices.
Source: Thomson Reuters