The Australian Dollar has proven resilient over the past year, averaging about 77 cents and continuing the shallow uptrend formed since a multi-year low around 70 cents in early 2016.
Looking forward, the Australian Dollar faces downside risks given Australia’s lower interest rates, lower economic growth and large foreign debt, a stronger US and possible rollover in China-linked commodity prices.
Australian interest rates below the US
Historically Australia has offered foreign investors premium interest rate yields. Indeed, since the early-1990s Australian-US cash and 10-year rate spreads have averaged 206bps and 130bps respectively.
In March, however, Australian cash rates fell below the US for the first time in 18 years. If the RBA leaves rates on hold at 1.5 per cent, while the US Fed continues its tightening cycle, the Australia-US cash and bond spread should reach 37-year lows late this year.
Beyond that, given Australia’s record household debt ratios, Australia is unlikely to regain a rate premium to the US.
Australian growth below US and Europe
Over the past 25 years, Australia has consistently offered foreign investors exposure to premium GDP growth, outperforming its Advanced Economy peers 89 per cent of the time, and by an average of 1.1 per cent pa. Australian growth, however, has fallen below both the US and Europe, something that should continue given the massive US fiscal stimulus, whilst Australia is held back by pressure on its household sector, elevated housing risks and a moderation in China.
Over the medium-term, Australian growth faces challenges. Population growth is now driving most of Australian GDP growth, with a lack of reforms and the end of the resources boom driving weak productivity growth.
Whilst strong infrastructure investment currently underway is positive, rising urban congestion should limit its impact. By contrast, the GFC and Eurozone debt crises have led to renewed reform, while an investment recovery is underway.
Commodities: Risk of China moderation
Booms in China housing and infrastructure investment over 2016-17 delivered a positive growth surprise and surge in commodity prices.
With President Xi reappointed for life, however, financial stability and sustainable growth have become key priorities. China represents around 50 per cent of global steel production, with a majority of end demand in construction.
With record iron ore port inventories, a slowdown in demand could push iron ore prices much lower. The iron ore price has fallen 16 per cent since the Lunar New Year in mid-February. Looking further ahead, as China converges on Advanced Economy levels of urbanisation, negative underlying demographics are likely to drive a dramatic decline in underlying commodities demand.