Barry Fletcher, Vice President and General Manager of American Express International Payments JAPA says that for many Australian businesses, the sheer size, scale and complexity of dealing in the foreign exchange market can be incredibly daunting. "It's critical therefore that business owners and managers develop a relevant strategy to maximise the opportunities and minimise their exposure to the volatility of FX markets,"

Fletcher explains that by doing so, a business owner or manager can create a much stronger level of certainty regarding this essential part of their business.

While many factors are pushing the Australian dollar higher at the moment, inflation is the real key to currency movements here and around the world this year.

Diana Mousina is an Economist with AMP Capital. She says 2017 was a strong year for the Australian dollar/US dollar cross trade.

“It had a better than expected year. The value of the dollar was forecast to drop to around 70 cents in 2017, but it proved to be quite resilient. So far in 2018 it has shown itself to be even more resilient than it was in 2017," she explains.

Mousina says that the relative weakness of the US dollar is one of the main reasons why the Aussie dollar has been so strong.

“That's been a function of the market," says Mousina. “The market has not priced in as many interest rate hikes by the US Federal Reserve for 2018 as the central bank has indicated."

She believes that's about to change. “AMP Capital expects the Fed to hike up to four times this year, whereas the market only expects two hikes."

Inflation will drive interest rate decisions in Australia and the US this year, with the Reserve Bank of Australia targeting inflation of between 2 per cent and 3 per cent, while the US Federal Reserve has a 2 per cent inflation rate target.

In Australia, inflation is sitting at 1.9 per cent, while in the US it's 1.5 per cent.

“There are a few different inflation measures in the US. The PCE Price Index looks at personal consumption and it's at 1.5 per cent," says Mousina, explaining that because inflation numbers have consistently disappointed, the US dollar has taken a hit.

Another reason the US dollar is so strong is because the market is anticipating the potential removal of monetary policy stimuli by major central banks such as the European Central Bank (ECB) and the Bank of Japan (BoJ).

The euro and the yen were exceptionally strong in 2017, due to strong European growth. This has led the market to price the potential for the ECB to remove monetary policy stimulus this year into currencies, with the euro and yen benefitting and the greenback's value declining at the same time.

The value of the euro has risen by 16 per cent over the past year while the yen is up by 3 per cent, with much of the appreciation in the yen occurring since the beginning of the year.

AMP Capital believes the market's reaction is overdone. Says Mousina: “We don't think the ECB will be able to raise interest rates this year."

The central bank's formal asset purchasing program is due to end in September, she adds, and until then, it will still buy assets in the market. “Which means rate hikes are a story for next year."

Growth in Japan has also been strong, she says. “But the BoJ is unlikely to be able to raise interest rates this year because inflation is still too low."

The ECB began buying assets such as bonds to support financial markets in the wake of the financial crisis. This program is tapering out as the economy recovers.

Commodity price growth has been much stronger than anticipated and is another reason why the Aussie dollar is performing well. This is because traditionally, when commodity prices rise, so too does the dollar as our economy is so dependent on mining and minerals.

Mousina notes that strong oil prices this year have helped drive the value of the Aussie dollar higher.

Local rate hike cycle

AMP Capital does not expect the RBA will lift the cash rate until late this year at the earliest.

“Inflation is below the target band and is expected to stay there for the majority of this year, which is the main reason we don't believe the RBA will lift rates," says Mousina.

She thinks the RBA will wait for inflation to strengthen to lift rates.

“The central bank is also looking for better economic data," she says.

“There are pockets of strength in the Australian economy, and some of the numbers that have come out this year have been quite good. Retail sales numbers are looking stronger and consumer sentiment is up. Business confidence is still really high and lately, the share market has been holding up."

Despite these signs of strength, Mousina still thinks the RBA will be cautious. “That's because it wants to tread carefully with inflation and it does not want to cause a situation where deflation emerges," she explains.

In a deflationary environment, asset values generally decline, which tends to dampen economic growth.

The situation is likely to change slowly this year; AMP Capital expects the RBA will raise interest rates in the December quarter by a 0.25 per cent.

“But we don't believe this will put upward pressure on the Australian dollar because we think the US Federal Reserve will lift rates four times this year. That interest rate differential between Australia and the US is still moving in the US's favour," Mousina attests.

Economic growth pick-up

It is anticipated the Australian economy will continue to recover this year, with AMP Capital forecasting economic growth of 2.7 per cent, after 2.3 per cent growth in 2017, according to the Australian Bureau of Statistics.

Areas driving growth higher include government infrastructure spending and net export growth.

“Mineral exports are strong, but this has been offset by some weakness in consumption. Housing investment is slowing, but the latest building approval numbers were positive. So, housing investment might not be as much of a drag on the economy as expected," says Mousina.

“Business investment is recovering because the peak of the decline in mining construction has passed. So, we're seeing a pick-up in mining business investment, which is positive. That's all contributing to growth," she says.

Nevertheless, AMP Capital's forecast of 2.26 percent by the fourth quarter of this year is below the RBA's estimated growth of 3.25 per cent.

And while it's not possible to come up with a definitive analysis of the impact of global stock markets, overall, the outlook for the Aussie dollar is fairly positive, Mousina says.

The continued economic expansion expected through 2018, is likely to help support the dollar and keep it falling from too far.

Key Takeaways

• This year's strong commodity figures have supported the value of the Aussie dollar.
• Economic growth is tipped to continue rising in Australia.
• The slowdown in mining investment is thought to have plateaued.