2023 has been a difficult year for the Australian Dollar (AUD). While the Australian currency started the year quite strongly, rallying to reach a year high of 0.7137 against the dollar, AUD quickly lost that ground and reached a low of 0.6296 in October. A minor strengthening in the last couple of months has raised coups that 2024 could be the year in which the Australian currency makes substantial gains against the dollar after several years of volatility. But how likely is that to happen?
The main reason for AUD’s decline against the dollar this year is the interest rate differential – the gap between the rates being offered in the States compared to in Australia. The Federal Reserve was the first major central bank to move quickly to hike interest rates in response to elevated levels of inflation. Interest rates in the US are currently at a 22-year high with the benchmark federal funds rate set between 5.25% and 5.5%.
The Reserve Bank of Australia (RBA) has not increased interest rates as much – partly because inflation in Australia, while higher than the 2-3% target range, did not reach the peaks seen in the States, the UK, or Europe. Therefore, the RBA increased the rate to 4.35% – substantially lower than that offered by the Federal Reserve, albeit still a 15-year high.
While lower interest rates can have positive economic effects, particularly by making borrowing cheaper and therefore encouraging consumer spending and business investment, this had negative effects on the USD/AUD exchange rate. Why would traders hold the Australian dollar when they can gain higher yields from holding USD, which also has the additional benefit of being one of the world’s safest financial assets? The differential inevitably caused capital outflows and a weaker Aussie dollar.
In an encouraging development for AUD, the Chairman of the Fed, Jerome Powell, recently suggested that the central bank would cut interest rates by up to 0.75% next year and said that it was “likely at or near its peak for this tightening cycle.” With Australian central bankers appearing to be holding steady on rates, at least for now, this could offer an opportunity for AUD. More lucrative yields compared to those offered by USD could encourage traders to shift their exposure to the Australian dollar, helping boost its strength and price on global foreign exchange markets.
However, much will also depend on commodity prices. The Australian dollar is highly exposed to commodity markets because of the extent to which the wider Australian economy is dependent on exports of natural resources. Australia is home to the world’s second largest accessible reserves of iron, the fifth largest reserves of coal, and significant gas resources. Iron alone accounts for almost 20% of Australia’s total annual exports.
Concerningly from Australia’s perspective, the World Bank’s commodity price index is expected to fall by 4% in 2024 on the back of sluggish global growth. Fitch Ratings predicts iron ore, for example, to trade at $95 per tonne in 2024 compared to $135 at time of writing – a decline of almost 30%.
This would be a downside risk for AUD for two main reasons. Firstly, exchange rates are partly a reflection of the health of the wider economy, and if a crucial part of the Australian economy is not performing as strongly, that will inevitably feed into the rate. Secondly, because commodities are priced in dollars, lower commodity prices would mean fewer US dollars coming into Australia. The result is less supply and greater demand relative to the existing supply of AUD, potentially driving up the value of USD at the expense of the Australian dollar.
One upside for the Australian dollar is the potential of stronger growth in China. High growth rates are positive for the Australian economy and exchange rate because Beijing is a key trade partner. Australia’s exports to China reached 19 billion AUD in March 2023, a record high. Greater economic activity in China would likely encourage Beijing to purchase even more commodities from Australia in order to power manufacturing and industry.
There is some optimism that China will finally leave behind its Covid-induced economic woes in 2024. The International Monetary Fund (IMF) recently upgraded China’s GDP forecasts for 2023 and 2024 and said the East Asian country has made a “strong” post-Covid recovery. Goldman Sachs analysts expect that China will set ambitious growth targets for the next twelve months, with Beijing potentially hoping to grow GDP by as much as 5%. Strong growth in China would likely spill over into increased optimism in AUD markets and give the Australian currency more room to make stronger gains.
It is likely that AUD will make some gains against the US dollar, particularly as the Federal Reserve begins a course of monetary loosening and China begins to grow more aggressively. However, any potential strengthening is likely to be limited given depressed prices on commodity markets upon which the AUD largely depends.
Author: Harry Clynch
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