Australian Dollar suffers from divergent policy outlooks

It has been a rough few weeks for the Australian dollar. The Aussie has lost nearly 3% versus the US dollar over the past month and many banking analysts are predicting the bad run to continue into 2018. The AUD was trading at 0.7566 against the USD on Monday, down from 0.7900 a month ago.

Why the poor performance? Perhaps the biggest reason is that the extra yield that Australian bonds currently offer compared to U.S Treasuries looks set to vanish in the coming year. This has not happened since 2000.

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A rising yield is typically bullish for a currency. Currencies can strengthen or weaken for a number of reasons but one of the biggest drivers is interest rate differentials. That is, what one currency is yielding compared to another. In the case of Australia, which has historically had a higher interest rate than the United States, this is about to change.

But why? In short, the US and Australian economies are diverging. The US is experiencing rapid job growth and some signs of inflation, which has caused the US Federal Reserve (Fed) to signal its intention to raise interest rates three more times next year.

Australia, on the other hand, has been hit with a slew of disappointing economic data that has caused the market to push back their forecasts for when the Reserve Bank of Australia (RBA) will raise interest rates. The RBA is now not expected to raise interest rates until the second half of 2018.

What this means in practice is that the United States looks set to have a higher interest rate than Australia in 2018. The higher yield that investors anticipate earning by owning the USD as opposed to the Australian dollar has been the primary driver for the AUD’s losses this past month.