Investors will spend time chasing down the best rate when their term deposit rolls over but how many think of using currency to increase the yield on their investments, lower their risk and get a diversification boost to their portfolio at the same time?
It’s an avenue we have watched closely at Citi and we are seeing savvy investors turning to USD investments as a strategy to gain a yield pickup.
The shift to USD investments is being driven both by an interest rate differential and the continued weakening of the Australian dollar to its US counterpart. We are often asked why the Australian dollar continues to decline in value, and one of the primary drivers for our currency is where the Reserve Bank of Australia (RBA) holds interest rates.
Interest rates drive currency direction
Currently the official interest rate set by the RBA is at an historical low of 0.50 per cent, following a rate cut earlier this month.
In the US, interest rates set by the Federal Reserve are in a band between 1.00-1.25 per cent. Markets are pricing in a minimum 0.25 per cent to come off in the first half of this year following the Fed's 0.5 per cent cut in earlier this month to combat COVID-19 effects.
Cuts or no cuts, US interest rates currently offer a yield advantage over Australia, and that provides the incentive for institutional investors to move large sums of money out of AUD and into a higher yielding currency like USD, which pushes the Australian dollar lower.
Other currency movers
While interest rates have a big influence on currency movement there are a number of other key elements, including a nation’s economic outlook. As mentioned, US cash rates are higher then Australia's, which is an indication of economic strength.
The US unemployment rate is also at 50 year lows, while consumer and business spending remain robust. A strong domestic economy is why we don't expect the US to move into recession this year or next.
The US also has other advantage that benefit its currency. It is a globally accepted currency, the currency of choice for international trade and it’s also known as a safe-haven currency.
The latter means in times of turmoil, like trade tensions, Middle East oil field bombings or pandemic viruses, money flocks to the safe haven of US dollars. Its helps support and boost the USD.
The difference that can make was clearly evident during the global financial crisis last decade, as the chart shows.
Australia’s economy is not in the doldrums but it does not have the confidence of the US economy and it is slowing. RBA governor Phillip Lowe recently referred to Australia’s “gentle turning point” towards better conditions but markets are certainly not pricing in any rate hikes this year.
The RBA will continue to do “whatever it takes” to avoid recession and their primary tool is to keep rates 'lower for longer'.
Interest rates in the US rose above Australian rates in 2018, since then the AUD has fallen from US80c, and been below US70c since April last year. We don't expect a meaningful rally while the US has a yield advantage, and it’s not an advantage that will disappear anytime soon.
Opportunities continue to present
Smart investors have been selling AUD on rallies since the rate inversion with the US, and that strategy is still in play despite the AUD now sitting around historical US66c lows. In the past three months there has been a 32 per cent increase in USD buying by Citi clients compared to the previous three months.
While we have seen some profit taking at these levels many investors are still looking for opportunities to sell AUD on rallies, but those opportunities may start to dwindle in frequency.
Peter is an investment specialist for Citi