As the extra yield available from investing in Aussie bonds over their US counterparts dwindles away to almost nothing, economists are looking for cracks in our surprisingly resilient dollar.
The spread between Australian and US 10-year government bond rates has historically served as a key driver for the Aussie dollar.
Last week, the difference between the yields offered on US and Australian 10-year government bonds dramatically narrowed to just 16 basis points, or 0.16 percentage points. The last time the yield differential was that low was in March 2001, when the Australian dollar purchased fewer than US50?? against US74.4?? now.
This debt yield spread has steadily declined since 2010, when it was over 250 basis points. But it has recently accelerated thanks to the divergent monetary policy paths of the Federal Reserve, which is focused on lifting official rates, and the Reserve Bank of Australia, which appears stuck in a holding pattern.
Even before last week's exceedingly narrow spread - which had been 23 basis points a week earlier - economists had been warning about the impact a low differential would have on the Australian economy. When the differential plunged to 30 basis points last month, TD Securities' Annette Beacher warned the currency could plunge to US62?? and cause an inflationary shock as the price of imports surged.
Yield spread narrows
Since April, the yield has only narrowed, as expectations solidified that the Fed would again raise interest rates at its June meeting. Meanwhile, a disappointing recent string of economic data has traders upping the chances of further easing from the RBA.
Based on pricing in futures markets, there is a 25 per cent chance of an RBA rate cut by the end of the year, on Citi data. The past two months has seen a rapid turnaround in the market's projected path of monetary policy - in March traders were pricing in a 40 per cent probability of a rate hike by the December RBA meeting, according to Bloomberg.
The impact this will have on the Australian currency has become a topic of much speculation. Over the past two decades, the dollar has lagged but followed the yield differential, although this hasn't been the case in recent months. Despite declining with the yield spread since 2010, the currency has maintained a tight trading band since the end of 2015.
Economists point towards the rise of China and the once-in-a-generation boom in demand for commodities as a key force underpinning the Aussie currency.
Australia's economy has generally offered higher interest rates than the United States, because investing in Australia, with its more volatile, commodity-exposed currency and more recently high exposure to China, is seen as a riskier proposition, requiring higher interest rates in order to be attractive.
As Australian interest rates stay on hold while the US' rise, AMP Capital's head of investment strategy and chief economist Shane Oliver said he expects the currency to fall below US70?? by the end of the year.
"The interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year as the Fed hikes rates and the RBA holds or cuts; constrained commodity prices will also act as a drag," he wrote.
RBC Capital Markets' Su-Lin Ong and Michael Turner have meanwhile speculated on the likelihood of the spread heading to zero, or even turning negative, in the remainder of 2017 - which would put even more pressure on the currency.
Hard to see it 'narrow much further'
"We have been of the view for some time that the benchmark 10-year Australia-US spread would stay in a broad 20-50 basis point range for much of 2017 given a number of push and pull factors," they wrote.
"Tight by historical standards, this range has largely prevailed since August 2016, and we have argued that it would be difficult for it to narrow much further on a sustained basis. Underpinning this view was our assessment that it would be difficult in a world of higher global yields for Australia to attract the necessary capital should this risk premium fall much further. Global capital effectively has more choice."
But as the yield differential plunged regardless, RBC's economists have been forced to revise their views. Below-target inflation and economic growth figures will put downward pressure on the RBA, they argue, and historically the central bank cash rates have been the key driver of yield differentials between the two countries. Given the RBA's likely stance, and the US Fed's, "we find it difficult to identify triggers for substantial widening".
Meanwhile, Capital Economics analysts, lead by chief markets economist John Higgins, said they expect US 10-year bond yields to rise - a factor that could push the differential with Australia's 10-year bonds even lower. "We think that tighter-than-expected Fed policy will drive up the 10-year Treasury yield by increasing the component that captures investors' expectations for rates. Such an increase has been seen in each of the last three major tightening cycles."
