The re-acceleration in momentum in China that we are envisaging should have positive spillovers into regional growth, emerging market assets, and Australia’s terms of trade, all of which have a positive correlation with the exchange rate. The currency could stage a more powerful rally if China’s economic revival proves to be more robust and commodity-intensive than anticipated.

AUDUSD vs. USDCNH

Another bullish setting could emerge if domestic macro conditions prompt a prolonged hawkish stance from the Reserve Bank of Australia. This could see relative interest rate expectations -which weighed down the Australian dollar over most of 2022 and 2023 due to the central bank’s more restrained approach – turn even more supportive than assumed.

The Bank’s efforts to navigate a soft landing and preserve as many jobs as possible while getting inflation down to target in a reasonable timeframe has seen officials raise rates at a slower pace than many of their global counterparts. We believe this pragmatic approach could limit the capacity to move as early or as far in future easing cycles. Based on the stickiness across services inflation, Australia’s poor productivity, slow-moving wage mechanisms, income-supportive tax cuts (starting mid-2024), and the demand boost from a surging population, we believe the central bank could again lag its peers. This time, though, policy sluggishness could become an Australian dollar tailwind.

Australia Inflation and Unit Labour Costs, annual % change

A more bearish scenario could play out if China’s economic troubles endure and stimulus supports fail to take hold. A soft growth pulse would be a negative for commodities and risk sentiment and could weigh on growth-linked currencies. Domestically, the jump in mortgage rates could also raise financial stability concerns given elevated household debt burdens and the banking sector’s property market exposures. A spike in unemployment generated by a sharp economic slowdown could also trigger adverse non-linear outcomes.

Real gross domestic product, annual % change

We see the Australian dollar edging higher over the next few quarters. This stems from our assessment that the US dollar should gradually lose ground, as growth differentials move against the US following a period of exceptionalism, as tighter conditions crimp activity, and Chinese stimulus measures gain traction, spilling over positively elsewhere. At the same time, on the back of our assessment that the Reserve Bank of Australia may be slower to move and/or deliver less interest rate relief than its peers elsewhere, short-dated yield differentials are expected to shift in support of the Australian dollar. According to our projections, the currency should drift up to $0.69 by mid-2024 and on to ~$0.71 by year-end.

Australian Dollar and Australia-US Yield Spread