I intend to take a deep look into the long term outlook for the AUD, not just incorporating technical analysis, but looking into the fundamentals and key drivers from a multitude of asset classes to decide where we go from here. To start with, by long term I mean far more than a year, and am considering events going 3+ years into the future, and while I understand this may not teach you how to make 25 pips a day or something rather trivial like this, it will show you how I gain a bias to the long term direction of a currency. Even if one does not utilise some of these ideas to trade very long term, they can all be used intra-day and for swing trades so it is applicable to all in my opinion.
Interest rate differentials:
A key driver for any currency is the interest rate differential - this is why monetary policy statements from various central banks are so key and this is very much the case for the Aussie dollar. As we can see below, there is a strong relationship between the 2 Year yield spread, a broad look at the interest rate differential.
Here we can split this chart into 4 distinct sections. The first being from 2000 through to 2003, this is where the Yield spread (green) rose from 0bps to around 375bps. Such a large rise was the reason for the 60% rise in the AUDUSD.
The next main period was from 2003/04 to 2006 where the yield spread tightened from 375 bps to merely 50 bps. However in this time the AUD barely moved and in fact traded flat for the majority of this time. The main reason for this was the dislocation between its risk tendencies (i.e. stock markets rising + China growing) and the decreasing yield spread.
The next two periods are sell explanatory when looking at the chart as the two lines correlated strongly pre and post 2008 crisis. Then we come to now. Where for the last 2 years the yield spread has been tightening - around 225bps in total. Only recently with the onset of the Emerging market sell-off and the slowing Chinese economy have we seen the AUDUSD start to drop. As a factor that kept the AUD elevated, when China showed signs of slowing it really hit hard, the only thing preventing it from trading towards 0.8 is the US equity market strength. Similar to the reason why the AUDUSD didn't fall in 2005/06.
So now we have had a look at the past for interest rate differentials, we need to consider where we are going from here. For this I'm using short term interest rate futures to predict the interest rate differential for a specific date in the future. Below we can see the respective implied yield curve for the US and for Australia for the next few years.
Yellow shows Australia and the purple line shows the implied yield for the US. In the bottom pane shows the interest rate differentials, which as we see quite clearly are expecting to decrease rapidly over the coming few years (note the time scale on the bottom is not linear!)
Either way, in 5 years the interest rate differential is likely to be around 50 bps and so this will have a huge impact on the AUDUSD.
Next up we can see the implied interest rate differential placed over the 1st chart to show the expected path for the 2 YR yield differentials.
As we can see, the line does drop off quite fast, and to expected we would see the AUDUSD eventually trade lower, but as in 2005 when the last interest rate differential tightening cycle occurred we may only expect to see the AUD trade modestly lower if risk markets are strong, for example China is growing well above 8% and US equity is continuing to push higher and higher.
However, either way you look at this we are unlikely to head too much higher from here and over the long term we are likely to drop to at least 0.8
Now looking forward into possible growth and inflation forecasts we can also examine the likely impact on the AUDUSD.
To start with, below we can see a chart showing the 5Y breakeven inflation rate (spread between 5 year bond and the 5 year inflation protected bond)
Australia in Green and the US in Blue show how for a long period of time Australia had a much greater expected inflation rate, however as is also shown, the actual inflation rate was fairly similar. for this reason the RBA had a much higer interest rate to compensate for the expectation, however high inflation never arose. Because of this the RBA are more prone to keep interest rates in a downward trajectory as inflation expectation have become the same as the US'
Here we can see AU Y/Y CPI in yellow and US Y/Y CPI in Red, as we can see they have fluctuated about a very similar level.
Next we can compare near-term growth prospects and their respective directional bias going into the coming few quaters. While this doesn't have a huge impact on the Currency, it shows a general barometer for the countries health.
Here we see AU GDP in white and US GDP in Purple with the spread below. As it stands now, Australia is growing 75bps faster than the US but this is decreasing fast as the US turns around (300bps just 3 quarters ago).
Because of the slowing AU economy and strengthening US economy this will put pressure on the AUD over time and so backs up the idea that the RBA is likely to cut rates or keep them low for a prolonged period of time and of course as we saw from the STIR futures this is expected.
All in all, this overview of the relationship between AU and the US, the interest rates and of course the AUDUSD all point to a much lower AUDUSD in 5 years time compared to now, and when referring to the main premise of this article, it allows me to have a bearish bias when trading the Aussie. For example selling the rallies over the longer term will play out well. for general disclosure purposes, I see the AUDUSD at 0.9 for year end, and trading as low as 0.75 in the next 18 months.