The last two or three years have been a volatile time for the Australian economy, and that has inevitably fed into the performance of the Australian Dollar (AUD). At the onset of the coronavirus pandemic in March 2020, the Australian currency plunged to almost historic lows against the greenback, at one point trading at $0.5738 against the US Dollar. Over the course of 2020 and 2021, the Aussie Dollar then made a sustained comeback, despite its trade war with China, and surpassed pre-pandemic levels, reaching around $0.79 by February 2021 – and staying in that range for several months.
This success proved to be short lived, however: by October 2022, AUD was in a downward spiral once more, amid wider USD volatility and the raising threats of a recession. At time of writing, the Aussie Dollar is trading at a solid but not spectacular $0.6615 against the greenback. Despite this, most analysts in the foreign exchange space seem to believe that 2023 could be the year in which AUD finally moves past all of this volatility and makes sustained gains. Will this be the case? Disruption Banking sees three main factors that could drive the Aussie Dollar’s strength this year.
Like almost all currencies, apart from the safe havens of the US Dollar and Japanese Yen, AUD was severely hit by the economic uncertainty provoked by the coronavirus pandemic. Foreign exchange investors flocked to USD and JPY, sending the value of the Aussie Dollar (and many others) sharply down. However, AUD’s struggles in that period were aggravated by its simultaneous diplomatic and trade war with China. After the Australian government criticised Beijing’s attempts to block international investigations into the origins of the pandemic, and banned Huawei from the country’s 5G network, China imposed huge tariffs on Australian wine and effectively banned the import of Australian coal. Given the large degree of dependency the Australian economy has on the Chinese markets, these tensions are partly responsible for the Aussie Dollar declining over 17% against USD.
There are signs these tensions are thawing. The most prominent foreign affairs hardliner in the Chinese government, Zhao Lijian, has been shuffled aside to an obscure post, which many traders are taking as a sign that China is seeking more cordial relations with Australia and the rest of the world. Beijing has moved to resume Australian coal imports and re-establish economic relations with Canberra. This is significant for AUD because of how closely correlated the performance of Australia’s currency and stock market is to the strength of commodity companies. In fact, AUD could emerge from this period of volatility stronger than before. During the trade embargo, many commodity companies sought to diversity away from China and started selling increased volumes to emerging markets in the Asia-Pacific region. Renewed engagement with Beijing could allow these companies to renew their sales to China, while maintaining new relationships elsewhere. This would be likely to boost the strength of AUD significantly, should the rapprochement with China happen in full.
The decisions of the Federal Reserve now impact practically every currency in the world, as we have previously explored with the Korean Won and pound sterling. Many currencies, including AUD, declined substantially after the Federal Reserve became one of the first central banks in the world to move aggressively to tame inflation. The Fed has now hiked rates up to 4.75% in response to rising prices in the States, with inflation peaking at 9.1% in June 2022. When this rate cycle began, it caused major problems for AUD. Should interest rates fail to keep pace with those in the States, it would seem inevitable that traders would choose to hold USD instead – why hold the Aussie Dollar when you can gain better yields on the US Dollar, which also happens to be considered one of the safest financial assets in the world? The Reserve Bank of Australia (RBA) managed to prevent serious declines by rising interest rates on ten consecutive occasions, but as the rate stands only at 3.6% (more than a percentage point less than in the States), its ability to make gains against the dollar is limited – for now.
This could change in 2023, with the Federal Reserve taking a slightly more dovish tone – and potentially easing off talk of further hikes. While any lowering of rates is unlikely to come before 2024 at the earliest, this should nonetheless give AUD some space to make gains. That said, any signs that inflation is not fully under control in the States could prompt the Fed to move aggressively again – something that Powell has alluded to in recent days. This would put renewed pressure on AUD and perhaps force the RBA into more hikes.
The Aussie Dollar is highly exposed to the price of commodities, which in turn is driven by global growth and demand for raw materials. This is a major downside risk for AUD. After all, the global economy is widely believed to be in a slowdown, with many major economies at risk of recession. Higher interest rates are also making access to cash – and therefore capital investment – more difficult, lowering the ability of companies to purchase raw materials and commodities. This would weigh on Australian mining shares, commodities indices, and probably the Aussie Dollar.
That said, AUD could be set for a boost thanks to the reopening of the Chinese economy, after three long years of “zero Covid” lockdowns. This should spur a renewed period of economic growth in China, with the resumption of construction and manufacturing projects that require (Australian) commodities. Indeed, most of China’s industrial production runs on coal power. Especially given this economic reopening comes at a time when China has resumed Australian coal imports, this could spur gains in AUD markets.
The signs are mixed for AUD as we approach the end of the first quarter. Closer diplomatic and economic ties with China are certainly a positive, as is the prospect of a more dovish Fed. However, there is also the possibility that slower global growth weighs on commodity demand and drags down the Aussie Dollar. More volatility could be in store after a tumultuous three years.
Author: Harry Clynch
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