This chart explains why the Australian dollar is under pressure

The Australian dollar is under pressure, falling to the lowest level against the greenback in more than four months earlier this week.

This chart helps explain why.

Source: NAB

From the National Australia Bank (NAB), it shows the spread between Australian and US 10-year yields going back to 2011.

Essentially, it’s what yield investors can receive for buying Australian government bonds compared to US bonds over the same period.

The difference between the two has been narrowing fast, falling from 295 basis points in 2011 — when the AUD/USD was trading above parity — to just 42 basis points this week, corresponding with the AUD/USD falling to fresh four-month lows.

The Australian dollar is gradually losing its yield advantage — both for short and long-dated bonds — helping to explain why it’s fallen substantially over the past few years.

While other factors such as commodity prices, risk sentiment and financial market liquidity are also influential on its movements, it’s clear that yield differentials are also an important factor.

Given the likelihood the US Federal Reserve will continue to lift interest rates in the period ahead, there’s now a very real possibility that the Australian dollar may lose its yield advantage over the greenback entirely at some point next year, especially should the RBA keep its key policy rate steady.

If that does occur, the NAB thinks the Aussie will come under further selling pressure.

“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,” it 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 finish the year around .7500, down from .7630 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.

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