Global volatility weighs on the Australian dollar
The Australian dollar's decline reflects policy prescription in the United States and weakness in China.
The Australian dollar has tumbled against the United States (US) dollar since the end of last year. Earlier this week, the Australian dollar was trading at 61 US cents, down more than 10% from a high of 69 US cents at the end of September 2024.
The story, however, is not so much about a weak Australian dollar as it is about a strong US dollar. The greenback has surged relative to almost all foreign currencies. Since the end of September 2024, the US Dollar Index, which indicates the value of the US dollar against a basket of foreign currencies, has climbed 8%.
The strength of the US dollar is likely to persist over coming quarters for several reasons. First, the Federal Reserve is now expected to cut short-term interest rates by less than previously expected, while longer-term rates in the US are likely to remain higher than in many other economies, including Australia, through 2025. Second, and arguably more consequential, is the new administration’s proposed policies. Suggested policies such as an increase in deportations and additional tariffs on imported goods could serve as supply shocks that hurt consumers and businesses by raising prices.
Other policies such as widespread deregulation of industries and an extension of tax cuts could boost spending and investment while worsening the budget balance. Over the medium term, this policy mix, if implemented, is likely to bloat the US fiscal deficit, push average inflation up, raise short-term and long-term interest rates, and strengthen an already strong US dollar.
Though important, the developments in the US are not the sole cause of the decline in the value of the Australian dollar. Indeed, the Australian dollar has also depreciated against a broader trade-weighted basket of currencies, including the Chinese renminbi, which has fallen sharply relative to the US dollar.
The US dollar and the Chinese renminbi currently account for almost 40% of Australia’s nominal trade-weighted index (TWI), which, like the US Dollar Index, measures the Australian dollar’s value relative to a trade-weighted basket of foreign currencies. The renminbi, which accounts for 30% of Australia’s TWI, is not solely determined by market forces. Instead, it is pegged to the US dollar daily. Therefore, when the free-floating Australian dollar falls against the US dollar it also tends to fall against the Chinese renminbi, pulling the broader TWI lower.
Chart 1: Australian dollar exchange rates
Source: Reserve Bank of Australia
Additionally, Australia’s terms of trade, driven by the price of major export commodities, is expected to deteriorate through 2025. This is particularly due to a structural slowdown in China which accounts for a third of Australia’s exports. An expected deterioration in Australia’s terms of trade will also weigh on the Australian dollar over the coming quarters.
Finally, because of the country’s significant economic links to China, global investors trade the Australian dollar as a proxy for China’s economic health. With China’s economy already facing domestic headwinds, an additional 10% tariff on exports to the United States is likely to negatively impact future growth prospects. This adds to the pressure on the Australian dollar.
A further slide is possible. The US’ proposal of markedly higher tariffs on imports from Canada and Mexico, who are two of its largest trading partners and joint signatories to a free trade agreement, opens the door to significantly higher tariffs on other trade partners such as the Eurozone and China. Countermeasures proposed by these trading partners could intensify trade frictions. As global trade comes under increasing pressure, the Australian dollar is likely to continue trending lower.
This newsletter was distributed on 5 February 2025. For any questions/comments on this week's newsletter, please contact our authors:
This blog was co-authored by Lester Gunnion, Manager at Deloitte Access Economics
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