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The Australian dollar has endured a volatile start to 2023 as a series of over-optimistic macro assumptions have been overturned. We think this could be a taste of things to come, with the world economy and markets entering a more challenging phase.

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Australian dollar turbulence is increasing, with the currency trading in a widening 450-pip band centered around the 0.67-cent mark in recent weeks. The exchange rate has been swung around by shifts in expectations around tightening cycles at the Federal Reserve and Reserve Bank of Australia, China’s faltering post-COVID lockdown recovery, and subsequent stimulus expectations, the downshift in global growth, Australia’s domestic economic resilience in the face of rising interest rates, and evolving risk sentiment.

We think these gyrations could be taste of things to come in the third quarter. The Australian and global economies have entered a more challenging phase, and markets will face more complex price dynamics. Inflation is proving to be far more “sticky” than many were assuming, and as long as this remains the case, the pressure on central banks to maintain restrictive settings – even in the face of a slowdown – will remain. It is a hard pill to swallow, but an extended period of sluggish growth and higher unemployment might be the price that needs to be paid for inflation to return to target. And while we think monetary tightening cycles are now largely discounted, we don’t feel the constrained macro environment is fully reflected in risk assets.

AUDUSD trading buckets, daily, since 1986

A stable global economy could provide support.

For the Australian dollar, a more bullish scenario than our baseline outlook would stem from China’s economic revival exceeding expectations – particularly if it is led by a policy-induced upswing in commodity-intensive infrastructure spending. Stronger momentum in China would be a positive impulse for Australia’s terms of trade, the domestic and regional economies, and the currency. In our opinion, the Australian dollar could also outperform if the global economy remains resilient in the face of tighter monetary and credit conditions, and inflation decelerates substantially without aggressive policy actions inflicting much damage on labour markets or generating financial stability risks. However, we judge this type of situation to be relatively unlikely.

Relative to our central case, a bearish scenario for the Australian dollar might stem from a deeper and more prolonged economic slump. A more significant slowdown is likely to flow through more negatively into commodity prices and risk assets, and weigh on growth-linked currencies. In a similar vein, a protracted period of high inflation could prompt central banks to continue to raise interest rates in the face of slowing activity and weakening labour markets, fanning the flames of financial stability concerns. This is particularly relevant for Australia, given the household sector’s high debt burden and the banking sector’s exposure to the property market

We are looking for the Australian dollar’s volatility to continue through the third quarter. We see the exchange rate oscillating in a 0.65-0.69-cent range as various crosscurrents play out. The list includes more market turbulence, global and Australian recession fears, China’s stumbling recovery and weaker renminbi, narrower interest rate differentials, the flow support from Australia’s current account surplus (circa-1.4 percent of gross domestic product), and solid underlying commodity demand from the global green energy push. But beyond the next few tricky months, our underlying view continues to be for the Australian dollar to edge up into the low 0.70’s by early 2024. We assume that once the worst of the economic downturn passes, signs of stabilising momentum, lower inflation, a sturdier Chinese economy, and a shift in stance from the Federal Reserve and other central banks – from rate hiking ‘inflation fighters’ to ‘growth supporters’ – should weigh on the arguably-overvalued US dollar and give cyclical currencies like the Australian dollar a boos

Australian dollar, actual versus estimates