Wednesday 09 February 2022 by FIIG Research Credit-Outlook-FX-Image General

2022 Credit Outlook - Foreign Exchange

Two key determinants of the exchange rate are the terms of trade and interest rate differentials. Despite the surge in commodity prices, the Australian dollar has at times failed to keep pace with both them, and our terms of trade. Part of this can be explained by rising prices that emanated from temporary supply disruptions rather than a sustained increase in demand.

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Another reason relates to the other main determinant of exchange rates, interest rate differentials, being the difference between interest rates in Australia and those in major advanced economies. The RBA introduced a number of measures that helped to lower interest rates along the curve, narrowing the interest rate differential, and with it, a lower Australian dollar than what would have otherwise been the case (certainly if the relationship between the Australia’s terms of trade and the dollar had been allowed to persevere).

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The RBA has remained comparatively dovish at a time when central banks around the globe are looking to tighten monetary policy aggressively. As such, despite unprecedented monetary and fiscal support reinforcing growth and commodity price expectations in 2021, the Australian dollar has remained relatively anchored.

As we look forward to the current year, the Australian dollar is likely to be largely influenced by interest rate differentials and the US dollar, with the latter sensitive to an aggressive US Federal Reserve that still appears to be assessing its options as it seeks to bring inflation under control. The RBA has judged that a necessary precursor to higher rates will be unemployment close to or below 4 per cent and wage growth returning to above 3 per cent. With progress toward both apparent, markets are pricing in three rate hikes locally in 2022.

If the RBA does not hike rates as markets are anticipating, or the US Federal Reserve signals an even tighter response, there is a real prospect of currency weakness, at least in the short-term, which could see the AUD/USD dollar retest the lows of late-2021 of 70c in early 2022.

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We would see more arguments in favour of a stronger Australian dollar throughout 2022. Assuming we see a more reactionary central bank locally, a realignment with commodity prices appears a reasonable prospect, although we don’t believe the RBA will be in a hurry to raise rates. And while commodity price indices point toward further growth, the pace is slowing. As such, we would lean toward an ascendency in AUD/USD toward mid-70c, but it may not materialise until later in the year.

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To read more about our foreign exchange outlook for 2022, you can download the full report here.