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Australian Dollar Forecast to Edge Lower Against Pound and U.S. Dollar Over Coming Months

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-AUD bucks Monday trend and rises against G10 peer group.

-Rabobank says rate-differential means gains to be short-lived.

-AUD/USD forecast to fall 4%, GBP/AUD eyes 10% upside.

© kasto, Adobe Stock

Latest forecasts from analysts at Dutch-based investment bank Rabobank show any strength in the Aussie Dollar will likely be short-lived as they forecast weakness in the currency over coming months.

The news comes as Australia's Dollar starts the new week on the front-foot, benefiting Monday from a Fox News interview in which US Treasury Secretary Steven Mnuchin said the U.S. and China have agreed to suspend a series of protectionist trade tariffs measures levelled against each other back in March, quashing fears of a so-called trade war between the world's two largest economies.

The U.S. Dollar was the top riser in the developed world currency basket Monday as a result of the agreement although the Australian Dollar came a close second thanks to the close trade ties between China and Australia.

However, the Antipodean currency had already seen among the greatest losses relative to the Dollar in 2018 after falling by 3.8% during the first six months of the year, and the Rabobank team say it won't be long before these losses renew.

This is because relative short-term interest rates have returned as the dominant driver of exchange rates and a downbeat outlook for Reserve Bank of Australia monetary policy has conspired with a trigger-happy Federal Reserve in the US to force the Aussie Dollar to its lowest levels since early 2017.

However that fixation on relative rates also means that, assuming the Fed sticks with its earlier guidance to keep raising U.S. interest rates at a steady and gradual pace, the Antipodean currencies are still amongst the most vulnerable in the developed world to another step higher in U.S. benchmark rates and bond yields later in 2018.

"There are some domestic reasons behind the softness in both the AUD and NZD since February. However, a large part of the movement in FX markets recently can be linked to a broad-based reappraisal in the outlook for the USD," says Jane Foley, an FX strategist at Rabobank. "Having hit our 3 month targets for both AUD/USD and NZD/USD we have lowered our forecasts moderately for both of these currency pairs."

Above: AUD/USD rate shown at daily intervals.

The AUD/USD rate is quoted 0.21% higher at 0.7525 at the time of writing while the Pound-to-Australian-Dollar rate is 0.54% lower at 1.7808.

Above: Pound-to-Australian-Dollar rate shown at daily intervals.

This price action comes amid a surge higher in U.S. bond yields, which saw the U.S. Dollar index swiftly convert what was a 4% loss for the 2018 year, into a 1.78% gain during recent weeks.

The 2-year U.S. bond yield reached 2.57% this week, its highest level since the financial crisis, while the 10-year yield sits close to a multi-year high of 3.11%.

Above: US ten year government bond yield.

Meanwhile, uninspiring economic data have seen the Australian 2-year bond yield fall back to 2.04% after touching a multi-year peak of 2.14% in April, while the 10-year yield has remained steadfastly below the 3% handle.

Above: Australian 10 year government bond yield.

The effect of these developments is that investors are further incentivised to sell Aussie Dollars and to buy the greenback in order to invest in the American bond market rather than vice versa. This is the opposite of how the so called carry trade, which has traditionally propped up the Aussie relative to its international peers, used to work.

For the Aussie Dollar, much will now also depend on where both U.S. and Australian central bank interest rates are headed.

"In comparison to other G10 central banks, market expectations for Fed policy have been relatively consistent and more hawkish this year. Even though our forecasts regarding inflation developments in the U.S. are on the moderate side of market expectations and our outlook for U.S. yields is tame, interest rate differentials still favour the USD," Foley says.

Foley and Rabobank team say the U.S. Dollar may now enter a period of consolidation but that the greenback should resume its corrective bounce higher before long and put renewed pressure on Aussie exchange rates. The only thing that could prevent this from happening is a sign of a sudden shift in RBA monetary policy.

"Although there is evidence in the inflation breakdown that core inflation is ticking higher, barring a significant increase in wage inflation, it seems likely that the RBA will remain patient on policy. Signs of a slowdown in the housing market provide further reason for the RBA to remain cautious in the coming months," Foley adds.

Australian interest rates have been held at a record low of 1.5% for approaching two years now and markets do not expect a change until well into the 2019 year. This is because Aussie inflation has remained below the central bank's 2% to 3% target for much of the last four years and the RBA can only raise rates as and when the consumer price index shows signs of holding sustainably at or above its target.

Conventional thinking on the subject says that, in order to lift inflation back within its target band, Australian wages would need to rise first.

However, the RBA estimates that the Aussie unemployment rate will first need to fall to 5% or below in order to foment wage pressures. And Aussie unemployment has remained remained stubbornly above 5.5% during recent months, suggesting inflation will remain below target, and the Aussie Dollar under pressure, for a while to come.

"On our assumption that the RBA holds rate steady this year, we see scope for AUD/USD to maintain a downward bias towards 0.72 on a 12 month view," Foley writes.

Foley and the Rabobank team forecast the AUD/USD rate will fall steadily over the coming year, dropping from 0.75 Monday to 0.74 in three months time and 0.73 by year end. It then declines to 0.72 in May 2019.

For the Pound-to-Aussie rate, Foley and the Rabo team forecast Sterling will rise from its 1.78 level Monday to 1.84 before the year is out and 1.95 before the end of the first quarter 2019.

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