The NAB just outlined why the Australian dollar will probably fall further

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The Australian dollar has been pretty dull recently, trading in a thin one cent range against the Greenback since late October.

It’s going nowhere, seemingly lacking a major catalyst to drive it either higher or lower.

The chart below from the National Australia Bank (NAB) tells the story, showing that since falling below key support at .7700, the AUD/USD has failed to go on with the move, finding buyers on any dip back towards the .7625 level.

Source: NAB

According to the NAB, the direction the AUD/USD heads next — be it higher or lower — will likely be determined by what happens in near-dated US and Australian bond yields.

“Yield differentials remain quite pivotal to our view of how AUD/USD plays out in coming months,” it says.

“The 1-year swap spread has compressed by around 13 basis points (bps) in the last month alone and by some 35bps in the past two months.

“This, along with the fall in the gold price, has been the main driver of the fall in our estimates of short term fair value since AUD/USD peaked on September 8.”

This chart from the NAB shows the impact narrower yield spreads between the US and Australia — along with a weaker gold price — has had on its short-term AUD fair-value model since the AUD/USD hit a high of .8124 in mid-September, completely offsetting the tailwinds delivered by gains in the crude oil price.

Source: NAB

On the narrowing in yield spreads, the NAB says this reflects both higher US bond yields and a reversal in Australian bond yields following tepid retail sales and inflation figures released in recent weeks.

Looking ahead, the NAB expects the spread between Australian and US bond yields will narrow further, creating renewed downside risks for the Aussie.

“Looking ahead, the prospects of rates cross-over next year, not just in term of policy rates but swap rates out to a year or longer, are becoming increasingly realistic,” the NAB says.

“Assuming the Fed moves in December, then one additional tightening in [the second half of] 2018 will see the fed funds rate above the RBA cash rate.”

As such, it expects the AUD/USD will probably break lower in the months ahead, seeing it trade closer to 75 cents by the end of the year from .7664 at present.

Longer-term, it sees the AUD/USD falling to 73 cents by the end of 2018, although it acknowledges it could fall even further should yield spreads turn negative.

“Rates cross-over represents a significant downside risk to our forecast,” it says.

“Swap rate differentials are likely to compress further, though for cross-over to occur as early as [the first half of] 2018 this will likely require some re-pricing for both Fed tightening and less RBA tightening.”

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