AUD/USD Dips on Rate Gaps, Yuan: Will Fed Shift Aid Rally?

Key Takeaway

• AUD/USD's performance is significantly influenced by US-Australia interest rate differentials and USD/CNY movements, explaining two-thirds of its fluctuations.
• Reduction in Fed rate-cut expectations and China's low-growth outlook are key pressures on the Aussie, with record shorts against it reflecting bearish sentiment.
• For a sustained rally in AUD/USD, a Fed pivot towards more accommodative policy and positive shifts in factors like the yuan and gold prices are crucial.

Dynamics of AUD/USD and Global Carry Trades

The Australian dollar's performance against the US dollar (AUD/USD) is significantly influenced by interest-rate differentials and the Chinese yuan's movements. In 2024, the AUD has faced challenges against its US counterpart, primarily due to shifts in Federal Reserve rate expectations. The currency pair's daily fluctuations over the past year have been closely tied to Australia's terms of trade, commodity indexes, and notably, the one-year Australian-US swap spreads and USD/CNY returns. These factors, particularly rate differentials and the yuan's performance, have been pivotal in explaining about two-thirds of AUD/USD movements.

The reverse carry trade phenomenon, where investors borrow in higher-yielding emerging market (EM) currencies to invest in the US dollar, has emerged due to the Federal Reserve's extended tight monetary policy. This strategy has yielded returns of up to 9% this year, with the Chinese yuan, among others, being targeted. This shift has placed additional pressure on EM currencies, including the yuan, which has implications for the AUD given its economic ties to China.

Rate Differentials and Yuan's Influence

The AUD/USD pair's fate is closely tied to the Federal Reserve's interest rate decisions and the economic outlook in China. Recent hotter-than-expected inflation data in both Australia and the US suggests a prolonged period of higher rates, affecting the interest rate differentials that drive AUD/USD. Additionally, the People's Bank of China's (PBOC) actions, including setting the USD/CNY fixings above 7.10, signal potential yuan depreciation, impacting the Australian dollar due to its status as a liquid proxy for yuan movements.

Asset managers and the leveraged community have shown a record bearish stance on the AUD, accumulating significant short positions. This sentiment reflects concerns over China's low-growth trajectory and its reduced demand for commodities, which directly affects Australia's export-driven economy.

Emerging Markets and the Dollar's Strength

The reverse carry trade's profitability underscores the US dollar's appeal in the current global financial landscape. The dollar's resilience, supported by a strong US economy and the Fed's monetary policy, has led to EM currencies' underperformance. With benchmark borrowing costs in several EM nations falling below US policy rates, the traditional carry trade has become less attractive, marking significant losses for investors using the dollar to fund EM exposures.

The outlook for EM currencies, including the yuan, remains cautious, with expectations of further depreciation to regain export competitiveness. This scenario suggests continued dominance of the dollar in carry flows, affecting global trade dynamics and currency markets.