Why is the Australian dollar low? Here's how interest rates affect the value of our currency

There are many economic factors, domestic and international, that can influence the value of the Australian dollar (AUD) against other world currencies. Over the past few months, the AUD exchange rate has dropped dramatically.

At the time of writing, 1 AUD is buying 0.66 United States Dollar (USD), according to Trading Economics. However, just a few months ago in February 2023, 1 AUD was worth more than 0.71 USD.  Two years prior, the exchange rate was even greater at 1 AUD/0.80 USD. 

Australia's dollar has fallen against many currencies already this year, such as the euro and the US dollar. It only rose against six G20 counterparts during the opening quarter of 2023, including the Japanese Yen, New Zealand Dollar, Norwegian Krone, Korean Won, Turkish Lira and South African Rand.

This currency disparity affects many aspects of our economy, including merchandise trade, capital flows, economic growth, right down to international holiday expenses. So, what's caused this sudden fluctuation in market value?

What affects the Australian dollar’s value?

Australia has a floating exchange rate, which means that movements in the AUD exchange rate are determined by the demand for, and supply of, Australian dollars in the foreign exchange market. There are a number of long-term and short-term drivers that affect demand and supply in this market, according to the Reserve Bank of Australia (RBA).

Long-term factors

Interest rates: Changes in interest rates set by the RBA can have a significant impact on the value of the Australian dollar. Generally, if the RBA raises interest rates, the Australian dollar tends to appreciate as higher interest rates attract foreign investment.

Commodity prices: Australia is a major exporter of commodities such as iron ore, coal, and natural gas. Therefore, changes in commodity prices can impact the value of the Australian dollar, as they affect the demand for Australian exports and the revenue generated by Australian exporters.

Economic performance: The overall performance of the Australian economy, including factors such as inflation, employment levels, and GDP growth, can impact the value of the Australian dollar. If the economy is performing well, the Australian dollar tends to appreciate as investors seek to invest in countries with strong economic fundamentals.

Global economic issues: The Australian dollar can be impacted by global economic factors such as changes in the US dollar, fluctuations in oil prices, and geopolitical events. These factors can create uncertainty and volatility in global financial markets, which can affect the value of the Australian dollar.

Short-term factors

Risk sentiment: The value of the AUD tracks movements in other financial markets and changes in ‘risk sentiment’ (how much risk investors are willing to take on in their investments). For example, if investors feel that the outlook for economic growth is more positive than before, they will be prepared to take on more risk.

Speculation: Investors may hypothesise about future movements in the exchange rate for a range of reasons, and buy and sell Australian dollars to make a profit, which affects the exchange rate.

How do interest rates affect the dollar?

Interest rates can have a significant impact on the value of the Australian dollar. Here are a few ways in which interest rates can affect the value of the currency:

Monetary policy: The RBA sets the official interest rate in Australia, and changes to this rate can affect the value of the Australian dollar. If the RBA raises interest rates, it signals a tighter monetary policy, which can increase demand for the currency and push up its value. Conversely, if the RBA lowers interest rates, it signals a looser monetary policy, which can decrease demand for the currency and push down its value.

Attracting foreign investment: Higher interest rates can make a currency more attractive to foreign investors, as they can earn a higher return on their investments. This increased demand for the currency can push up its value.

Affecting inflation: Interest rates can influence inflation, as they impact borrowing costs and the cost of goods and services. If interest rates are too low, inflation can increase, which can decrease the value of a currency. On the other hand, if interest rates are too high, inflation can decrease, which can increase the value of a currency.

Why are interest rates affecting the value of the dollar more than they normally would?

Directly, when other central banks raise their interest rates, it can make their currencies more attractive to foreign investors seeking higher returns. This increased demand for these currencies can cause the value of the Australian dollar to fall relative to these currencies, as investors move their capital to other countries with higher interest rates.

Indirectly, higher interest rates in other countries can also affect the Australian economy and, therefore, the value of the Australian dollar. When other countries raise their interest rates, it can lead to a tightening of global liquidity conditions and a decrease in the availability of capital for investment. 

This can result in a slowdown in global economic growth and a reduction in demand for commodities, which can have a negative impact on the Australian economy due to its reliance on commodity exports. A slowdown in the Australian economy can weaken the Australian dollar, even if the RBA does not change its own interest rate policy.

Presently, interest rates in other economies around the world are generally much higher than in Australia.

Why do other economies have much higher rates?

In Australia, the RBA sets the cash rate and banks typically pass on these changes to borrowers. When the cash rate goes up, homeowners may have less money to spend as they struggle to cover higher interest on their mortgage.

Variable rate home loans are the norm for most borrowers in Australia, so when the RBA decides to increase the cash rate, it affects the majority of mortgage holders. Fixed rate loans, on the other hand, are not as common and usually only last for a few initiatory years.

Unlike in Australia, where variable loans are widespread, fixed rate loans with terms as long as 30 years are common among borrowers in the US. Therefore, when the Federal Reserve decides to raise rates, only a segment of mortgage holders (mostly new homebuyers) may be impacted.

Housing is also much more expensive in Australia, compared with the US. The average house in Australia costs $8470 per square metre, while the equivalent price in the US is less than $2541 per square metre, according to data published on The Unassuming Economist blog by Prakash Loungani, an assistant director and senior personnel and budget manager in the International Monetary Fund’s (IMF) independent Evaluation Office.

Therefore, it’s much more difficult to curb spending in economies like the US by raising interest rates.

Inflation doesn’t drop if people keep buying things and because interest rates in countries like the US are having a much softer impact on mortgages, it’s contributing to prolonged inflationary conditions.

What's next for AUD/USD?

While it’s very difficult to predict what might happen to the Australian dollar’s value against other global currencies, the big four banks and other institutions and economists have offered forecasts.

It’s important to understand that these forecasts are simply estimations and are subject to change.

CBA

There are three main reasons for the forecast poor performance of the Australian dollar against the US dollar (AUD/USD), according to CBA head of international economics Joseph Capurso. These are commodity prices, China’s post-pandemic recovery and interest rate differentials.

“The main reason for the fall in AUD is the fall in commodity prices. China's two sessions meetings did not deliver policy stimulus that we expected to support metal prices.

"The two year interest rate differential with the US is also heavily weighing on AUD/USD.

“The main risk to our AUD/USD forecast is if China's recovery is weaker than we expect. In particular, the Chinese economy has not rebounded strongly like other economies have following the removal of lockdowns. However, it is possible Chinese authorities resort to infrastructure investment if the advanced economies recession is deeper than expected.”

CBA economists are the most pessimistic regarding the strength of the AUD/USD currency pair, suggesting that it will be a much slower path to recovery over the next year. The bank expects the exchange rate to slip over the next quarter to June 2023 - the only big four bank to predict a fall - and for the rate to reach just AU$0.68 to US$1.00 by June 2024, significantly lower than the other big four bank’s expectations for the same period.

Exchange rate forecasts:

Source: CBA exchange rate forecasts, published April 2023.

ANZ

The bank is predicting that the AUD/USD pair will gain some strength over the course of 2023, however, the outlook remains unclear and so, they have very mildly underweighted the Aussie dollar, according to ANZ head of investment strategy, private banking & advice Lakshman Anantakrishnan.

“Like bond and equity markets, global factors such as recession risks and geopolitical threats will likely remain key drivers of the local currency in the first half of 2023, as the market shifts its attention from inflation to growth. While the AUD may struggle against this early, overall we expect 2023 to be a better year than 2022 for the Aussie dollar, and some broad-based USD weakness in H2 2023 should help lift the AUD and other cyclicals into year-end. With the outlook unclear, particularly for the first half of 2023, within portfolios we are very mildly underweight the AUD, favouring developed market, foreign currency exposure — particularly the US dollar.

NAB

The bank expects the AUD/USD pair will improve by the second half of 2023, recovering the losses it sustained during the first quarter of the year. NAB predicts that the Australian dollar will continue to close the gap with the US dollar over the next two and a half years, leading to an exchange rate of AU$0.78 to US$1.00 by September 2025. 

Spot Exchange Rate Forecasts:

Source: NAB spot exchange rate forecasts, published March 2023.

Westpac

Westpac expects the AUD/USD currency pair to improve slightly by June 2023, while a more significant recovery isn’t anticipated until the end of the year. The bank forecasts that the Australian dollar will maintain its strength throughout 2024, extending to an exchange rate of AU$0.77 to US$1.00 by December 2024.

Exchange Rate Forecasts:

Source: Westpac exchange rate forecasts, published April 2023.

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