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Interest rate differentials between the US and Australia are set to narrow further, creating Foreign Exchange opportunities for investors
Recent economic data from the United States indicate the US economy is cooling at a sufficient pace to allow the US Federal Reserve to end hikes in this interest rate cycle. It’s a scenario that has implications for the US dollar and raises potential opportunities for investors.
Since the end of October, a string of economic data has supported a scenario of a cooling US economy and a reasonable path for the US Federal Reserve (Fed) to meet its inflation target. The US headline inflation rate for October of 3.2% compares to a peak of 9.1% in June 2022, and core Personal Consumption Expenditure (PCE), which measures goods and services inflation is down to 3.7%. A contraction in the key ISM Manufacturing Index in the 3rd quarter of 2023, indicating a slowing economy, has also reduced pressure on the Fed to raise rates further.
Although a peak in US rates supports a weakening US dollar, global geopolitical risks may make for a bumpy US dollar (USD) depreciation cycle. It is this potentially fluctuating downward track that can provide investors with currency opportunities.
The case for a weaker US dollar
Both the Fed and Reserve Bank of Australia (RBA) started to hike rates in early 2022 but the Fed moved at a faster pace, resulting in more than one percentage point interest rate differential for most of 2023. This has not only meant US inflation fell quicker than in Australia, but it also supported a strong USD against the Australian dollar (AUD). Through the third quarter of 2023 the US Dollar Index (DXY) gained 3.8%, while the AUD depreciated 4.5% against the USD.
Ongoing strength in the USD has run its course recently. The Fed’s November decision to keep the 5.25%-5.5% target range for the federal funds rate at its 22 year high marked the second consecutive hold since July.
Markets have strongly signalled that rate hikes are over, with expectations there will be 100 basis points of US interest rate cuts in 2024. In contrast, the Fed’s dot plot indicates only 50 basis points cuts over the same period. Either scenario provide the preconditions for the US dollar to further weaken.
Compared to the US, Australia has a more stubborn inflation issue as headline inflation at 5.4% is still 2.4% above the RBA’s minimum acceptable inflation target of 3%. This inflation issue underpins the RBA’s higher interest rate bias, and it is why NAB Economics expects another rate rise early in 2024. If the Fed cuts rates or the RBA raises rates higher in 2024, the interest rate differential between the US at 5.5% and Australia at 4.35% will narrow, which could act to push the Australian dollar higher.
Influence of the USDs safe haven status
The weakening of the US dollar was a popular market thematic at the end of 2022 as many were expecting a US recession induced by aggressive Fed rate hikes and a China economic recovery brought by the lifting of COVID-19 related restrictions, creating relative strength of the Chinese Yuan. Neither eventualised, and the dollar did not weaken as much as expected. In fact, in the year to date November 30 2023, the DXY remains flat. Just as previously, the path to USD depreciation may not be smooth.
How investors can get positioned
Lower rates in general support higher assets prices, and long duration assets such as fixed income can benefit more as the economy slows down. After touching 5% on October 19, US 10yr yields dropped by 50bps in a month to 4.5%. This bond rally in part was fuelled by the peak in the Fed rate narrative.
Alternatively, investors looking for more flexibility may consider tailored FX solutions, such as Currency Linked Structured Deposits, which includes Bear Structured Deposits and Bull Structured Deposits. In a Bear Structured Deposit, investors set a floor price – which is an exchange rate lower than the currency spot price. Investors earn the maximum income rate return available under the deposit if the floor is reached. However, the minimum income rate return is paid if the currency trades above the floor during the term of the deposit. This structure helps investors earn income without risking their capital. It can also be used to offset a drop in US long positions, assuming the floor is reached, and the maximum income rate applied. Bull Structured products work the other way, where investors can earn a higher return if the spot exchange rate touches their pre-determined ceiling price during the term of the investment.
These type of FX solutions can offer investors higher income in periods of heightened FX volatility. As Fed rates peak, FX market volatilities can pick up in response to heightened market activity and diverging views on the economic outlook. That said, investors must carefully consider their own risk appetite for exposures in FX markets, as an unexpected shift in market sentiment can impact investment outcomes.
The information contained in this article is gathered from multiple sources believed to be reliable as at November 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. Past performance is not necessarily indicative of future results. No warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither NAB or any of its related entities accept liability to any person for loss or damage arising from the use of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.
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