The Australian Dollar will probably strengthen marginally versus the British Pound over coming months we are told.

Political uncertainty is expected to keep the Pound depressed as long as the details of a final Brexit deal remain unclear while the Australian Dollar might gain strength from a re-evaluation of the economic outlook.

Analysts at HSBC suggest the Aussie could benefit as markets row back from their over-pessimistic stance towards the currency.

Whilst the economic surprise index has been falling as a result of negative surprises to worsening trade data in Q1, the market may have overestimated the damage to the economy.

The economic surprise index is an indicator of economic strength - if economic data surprises for the better, the index heads higher, and the opposite is true when the economy starts underperforming expectations.

“There are now signs the market may have got too bearish on Australian macro. For instance, while Q1 GDP growth was undoubtedly weak at just 0.3% Quarter-on-Quarter (QoQ), this was in line with consensus expectations. That AUD-USD gained 0.5% immediately after the release suggests the market feared much worse, perhaps a negative QoQ print,” says HSBC’s Strategist Daragh Maher.

The Reserve Bank of Australia’s stance on the economy has also been more upbeat, after they suggested the poor Q1 GDP result was a consequence of “quarter-on-quarter variation in the growth figures”.

Analysts, including HSBC have also put the Q1 data’s weakness down to outside factors such as Cyclone Debbie and the weather.

“With the labour market also showing upward momentum recently, we think near-term risks around data releases and RBA policy may have tilted to the upside for the AUD,” said Dragher.

The Erosion of Carry

"Carry" is a type of investment which involves borrowing a currency in a low interest rate jurisdiction such as the Eurozone or Japan and using the money to buy a currency with a relatively high interest rate such as the Australian Dollar or the Indian Rupee.

When interest rates were low amongst G10 currencies about a year ago there was a lot of Carry flowing into the Australian Dollar which strengthened as a consequence.

Since then US interest rates have risen, however, and Australian rates have fallen leading to a decline in carry flows into AUD.

“Yet the influence of carry is likely to be lower now, given the recent rapid erosion of yield differentials to the lowest levels since the early 2000s (eg 10Y Australian government bonds now yield just 20bps over US Treasuries, 60bps for New Zealand),” commented HSBC.

The fall in carry trade demand was a major factor in Australian Dollar weakness in April and May 2017.

“With the carry buffer diminished, the AUD in particular has proved more sensitive to negative cyclical developments and was the worst performer in G10 currencies through April and May.