There is a "realistic" prospect that in 2017 interest rates in the United States will be higher than in Australia for the first time in 15 years, NAB economists say. The last time this happened, the Aussie dollar plunged as low as US48¢.
The Australian currency last fetched US72.08¢ and looks set to end the year lower after starting 2016 around US73¢.
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Winners and losers of US dollar surge
The US dollar climbs towards a 14-year peak as global markets adjust to the idea of higher US interest rates, triggering worries over who stands to lose from a higher greenback.
The Federal Reserve funds rate now stands at 0.75 per cent, and the Reserve Bank of Australia's official cash rate target is at 1.5 per cent. But there are a number of permutations that could result in tighter official monetary conditions in the US than down under, NAB global co-head of currency strategy Ray Attrill said.
One possibility is the US Fed could raise rates by a quarter of a percentage point four times with no change from the RBA. Or there could be three rises from the Fed - the current median projection from members of its monetary policy setting committee - married to one cut from the RBA. Alternatively, the Fed might hike twice, while our central banks eases twice.
That last scenario is NAB's current forecast, but "none of these combinations are implausible," Mr Attrill said.
Traders' bets
According to pricing in fixed income markets, there is a one-in-four chance of three US rates hikes by this time next year, and close to a one-in-three chance of two hikes, according to Bloomberg numbers. There is a 13 per cent chance the Fed will lift four times in 2017.
For the local cash rate, traders are factoring in higher odds of one rate hike by November - 34 per cent chance - against only a 3 per cent chance of a quarter-point move lower. The odds of rates staying steady at 1.5 per cent for the bulk of 2017 are over 50 per cent.
While there is precedent for a collapse in the local exchange rate, Mr Attrill said he did not see the Aussie dollar dropping "much below 65 US cents, other than in the midst of a US-instigated trade war" – of the type investors fear US president-elect Donald Trump might spark if he translates tough rhetoric, particularly against China, into more tangible measures such as tariffs.
![Federal Reserve chief Janet Yellen: for the first time in 15 years, higher rates in the US than in Australia are a ...](/web/20161231031453im_/http://www.smh.com.au/content/dam/images/g/t/b/f/o/i/image.related.articleLeadwide.620x349.gtj8ij.png/1483107109595.jpg)
While interest rate differentials play a large role in determining the relative strength of currencies, it is not the sole factor. One major reason for Mr Attrill's more benign view of the currency is that our terms of trade currently sits around 40 per cent above the average level that prevailed between 1997 and 2001.
That's thanks to the recent once-in-a-generation resources boom driven by the industrialisation of China and its hunger for natural resources such as iron ore and coal.
Today's stronger terms of trade implies "a significantly higher level" for the Aussie dollar compared to the turn of the millennium, Mr Attrill says. He calculates that "crudely, the current equilibrium trade-weighted index [for the Aussie dollar] is some 20 per cent above 1997-2001 average levels".
'A lot has to go wrong'
Secondly, the late Nineties "was a quite unique era from a global capital flows perspective", in which the the US tech sector was sucking in international money from investors keen to capitalise on the Dotcom boom, regardless of differences in global interest rates.
Finally, Australia's currency weakness was exacerbated when the economy flirted with recession in the second half of 2000 following the introduction of the GST in July of that year. Unemployment rose to 7 per cent from 6 per cent in the 18 months following the introduction of the tax, to which the RBA responded by slashing rates by two percentage points in 2001.
"One thing we know for sure is that the RBA will not be cutting rates by 200 basis points in 2017," Mr Attrill said, although he added that "a flirtation with unconventional monetary policy comes onto the radar if circumstances dictate a cut to 1 per cent" - a level that the central bank has hinted is the lower bound for conventional policy.
"Our conclusion is that a lot has to go wrong in Australia, alongside unrelenting US dollar strength, if the Aussie-US dollar exchange rate is to come close to re-running its late 1990s-2001 experience," Mr Attrill said.
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