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Australia's Dollar is unlikely to offer an exiting domestic backstory in 2018 but its worst days are probably behind it, and the currency still presents a cheap opportunity to bet against the US greenback.

February’s US Dollar rise is merely a corrective move, according to BNP, that will not be sustained.

International investors have built up large US Dollar positions in the years since the financial crisis and with the Federal Reserve now deep into a hiking cycle and the rest of world economy picking up these investments are being unwound and funds repatriated.

As a consequence the US Dollar has come under increasing pressure in the last year, so much so that the Dollar index dropped by 11.3% over the last 12 months. This unwinding of international Dollar investments is expected to continue for a while yet, adding further pressure on the Dollar.

“BNP Paribas STEER™, our short-term fair value model, indicates that the decline of AUDUSD in recent weeks provides an attractive opportunity to establish a long position,” says Sam Lynton-Brown, an FX strategists at BNP Paribas.

Australia’s Dollar has fallen steadily from around 0.81 at the start of the month, to 0.78 Friday, as risk currencies fell from favour with investors in the wake of February’s stock market collapse.

The sudden and vicious rout in global stock markets spooked investors, who responded with a classic flight-to-safety that drove flows back to the Dollar. The greenback has also benefited from an increase in long term US bond yields.

“In Australia, growth remains relatively robust at a pace of around 3% but, with potential growth at around 2.75%, this does not translate into substantial inflation pressures,” says Lynton-Brown.

“The Reserve Bank of Australia (RBA) forecasts core inflation reaching 2%, the lower bound of its 2-3% target range, by the middle of next year.”

Like in many other countries, Australian inflation has been held back by subpar wage growth, which is weighing on consumer spending amid high levels of household debt.

“Australia is not yet at full employment – the unemployment rate stands at 5.5% versus the RBA’s estimate of NAIRU at or below 5.0% – which is weighing on wage growth. And low wage growth is keeping core inflation subdued,” Lynton-Brown adds.

The latest example of weak pay growth came in Wednesday’s December quarter wage cost index, which showed private sector pay growth remaining close to a record low and lagging that of the public sector.

Wage pressures, and labour markets by implication, are the most important macroeconomic variables in the global interest rate equation at the moment given their significance for inflation.

Central banks can only raise interest rates in response to changes in inflation pressures, while it’s expectations of higher or lower interest rates that dictate the respective fates of the currencies tied to them.

“We do not necessarily think pricing in of the first hike is likely to be brought forward significantly, but we do see scope for the market to more fully price in a tightening cycle over the coming years. And in any case, the AUD rates market is very unlikely to shift back to pricing in rate cuts, in our view,” says Lynton-Brown.

The Reserve Bank of Australia held its cash rate at a record low of 1.5% for the 19th month in a row this February and pricing in interest rate derivatives markets currently implies that rates will remain here until May 2019.

“As the outlook for the AUD is relatively benign, we think the AUD is attractive to express our structurally bearish view on the USD, particularly as (along with the NZD) it is the only G10 currency where running USD shorts is not expensive from a roll down perspective,” Lynton-Brown writes, in a note Friday.

The interest rate outlook means Australia’s Dollar is unlikely to offer an exiting domestic backstory to traders over the coming months, but the Aussie's worst days are probably behind it and the currency still provides traders with a cheap opportunity to bet against the US Dollar.

This is because American interest rates are still lower than their Australian counterparts, which means interest rate differentials favour those who hold Aussie Dollars over US Dollars. Favourable rate differentials can offset some of the cost of speculative trading and investment.

Lynton-Brown and the BNP Paribas FX team recommend that clients of BNP Paribas buy a six month AUD/USD Call Option with a 0.86 cent reverse-knock-out attached, which costs 0.61% at the current market price of 0.7815.

This will return a profit if the AUD/USD rate rises above 0.80 but the option will expire worthless, meaning the trader does not make money, if the exchange rate rises above 0.86 in the next six months.

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