The under-appreciated effects of FX appreciation
The USD sell-off has caused the AUD to appreciate beyond what the recent shift in the rates outlook would imply.
- Geopolitics and AI-generated investor nervousness have contributed to a growing pivot out of the USD since the beginning of the year, if not out of US-domiciled assets necessarily. The result has been compressed credit spreads elsewhere and vibrant activity in non-US credit markets, including Australia.
- The USD has therefore depreciated noticeably in recent weeks but remains overvalued on standard metrics, though less so than a year ago. The AUD has appreciated even more, with a bit more than half the shift in the TWI since the beginning of 2025 being an arithmetic consequence of the USD move. The rest is attributable to other factors, including but not limited to the shift in the rates outlook over the past couple of months.
- Normally, the AUD moves in ways that offset other shocks rather than being a shock in its own right. However, the nature of the USD sell-off and shifts in hedging suggest that the appreciation could dampen imported inflation by more than is implied by rate moves alone.
If the procession of geopolitical events in the year’s opening weeks wasn’t enough, global markets have been buffeted by a growing pivot out of USD-denominated assets. Some of that pivot has involved investors retaining exposure to the underlying US assets but hedging the exchange rate exposure, while in other cases, portfolios are being reallocated outright.
This ‘de-dollarisation’ pivot has in part been driven by the various geopolitical events of recent weeks, many of which are seen as US-negative and USD-negative, but there is more to it than that. Compounding the nervousness has been ongoing uncertainty about the implications of the AI technology and investment boom. The major players’ investment plans are of such enormous scale that digesting the resulting issuance will inevitably affect the market more broadly. This is especially so when we are already seeing cases where investment with an economic life of less than a decade is being funded by a 100-year bond issue.
Another element of this nervousness has been seen in negative equity market reactions to recent releases of new AI products that are seen as potentially disrupting incumbent industries. We remain of the view that these new technologies will not destroy jobs and industries in the way some fear. After all, the intellectual property of a software firm is less that they have people who know how to code, and more that they have people who know what makes a good payroll system, or drawing software, or whatever it may be. That design knowledge is harder to ‘vibe’ than the code. But for now, the rate of change is so rapid that the first reaction will be fear, until the broader implications can be worked through.
An intense appetite to invest in credit products means that neither the shift out of USD or the boom in AI investment funding has materially shifted fixed-interest pricing in the large US and other major markets. For example, 10-year government bond yields are little changed over the past couple of months. Rather, we see the impact in compressed credit spreads, and in smaller debt markets such as Australia’s, where issuance volumes have expanded to take advantage of strong investor demand. New participants have entered both sides of the Australian credit market and activity broadly has been vibrant.
The pivot out of USD assets has materially contributed to a sell-off of the USD in recent weeks. Over the past month, DXY is down around 2%, and it touched even lower levels in late January. Despite this, standard metrics still show the USD as moderately overvalued, with the real effective exchange rate around 12% above its long-run average. This overvaluation was even more pronounced at the beginning of 2025 and has progressively unwound in fits and starts.
Meanwhile, because the Chinese currency is closely managed to maintain its USD exchange rate, it has moved relatively little in trade-weighted terms. But because inflation has been much lower there than in the US and many other major industrialised economies, its real effective exchange rate is around 15% below its peak in early 2022. The resulting increased competitiveness is one reason why China has been able to meet its growth targets by increasing exports.
Domestically, the main result of these developments is that the AUD has appreciated noticeably. In trade-weighted terms, it is up 5% since the beginning of the year and 10% since the start of 2025. These are large shifts that cannot be entirely attributed to the higher rates outlook in Australia recently.
To be fair, the rates environment has contributed: yields on Australian 10-year sovereign bonds are now around 65bp above their US equivalents, despite the Australian sovereign being more highly rated, after being closer to flat in the middle of last year. This has made Australian assets particularly attractive to global investors, within the broader pivot away from USD-denominated assets. But if shifts in domestic rates alone had been the driver, cross-rates against other currencies would have risen by more than they have done; in particular, AUD/EUR would not be below where it was at the beginning of 2025.
At least some of the AUD’s appreciation instead stems from other factors, including higher prices for some key commodities and the previously mentioned sell-off in the USD. Many of the entities increasing their hedging or reallocating new flows are Australian superannuation funds, so the impact on the AUD/USD exchange rate can be expected to be pronounced.
The AUD/USD bilateral rate is up nearly 15% since the beginning of last year, versus 10% on the TWI. The USD and CNY together have a roughly 40% weight in the trade-weighted index, and slightly less than that in the RBA’s import-weighted index. A crude way of thinking about this is that the USD bilateral move, and accompanying CNY move, accounts for 6ppt of the 10ppt move in TWI since the beginning of 2025. Since the AUD/USD rate would have moved anyway with the higher Australian rates outlook, not all of this relates to the USD sell-off. Again, though, movements against other major currencies imply that most of it was USD-driven.
Another way of thinking about the appreciation is through the lens of the real effective AUD exchange rate (using the IMF monthly real effective exchange rate data supplemented with nominal TWI movements, given the RBA’s quarterly index only goes to the December quarter). The 5½% lift in this measure in February to date compared with December is considerably larger than the impact of the roughly 100bp shift in the interest rate path implied by the RBA’s own models.
If the AUD remains at this level or appreciates further, some downward pressure on inflation in imported items can be expected over the next year or two. While estimates are necessarily imprecise, there are good reasons to think that size of the effect will not be fully captured in the impulse response from interest rate shock to inflation in a whole-economy model. Our assessment is that – partly for timing reasons – the RBA might not have fully incorporated this possibility into its February forecasts or assessment of risks.
In this week’s Market Outlook publication, we highlighted several reasons to expect that the current elevated inflation rate will unwind over time. Some of them, like the conclusion of public infrastructure projects and their impetus to demand, are purely domestic developments. The exchange rate appreciation, on the other hand, depends a lot on how attractive US markets remain to global investors or whether the sell-off continues.
This is quite a different dynamic to how policymakers usually think about the exchange rate. Normally, the AUD is seen as a shock absorber, the depreciation that cushions the effect of a global downturn, or the appreciation that absorbs and widely distributes the benefits of a commodity boom. Policymakers in Australia remember the difficulties their NZ and Canadian counterparts got into back in the 1990s by treating the exchange rate as an independent factor in a Monetary Conditions Index. It is therefore understandable that they might downplay a move that happened at the same time as the rates outlook moved a lot.
This time round, though, it will pay to keep a weather eye on the implications of global asset reallocation and Australian hedging patterns for AUD, and what this might do to the cost base for imported goods.
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