The chart above shows, how the relationship between AUD/USD and 2-year yield divergence has unfolded since 2012.

• It can be seen even with a naked eye, that the pair and the yield spread between 2-year treasury and 2-year Australian government bond have enjoyed a very close relationship.
• While the Reserve Bank of Australia (RBA) reduced rates after the financial crisis of 2008/09, it soon started increasing interest rates due to higher commodity prices and higher inflows from other western economies. However, as commodity prices started declining in 2011, RBA started reducing rates since the end of 2011.
• RBA reduced cash rates from 4.75 percent in 2011 to 2 percent by the summer of 2015. And the yield spread between the two countries declined from 2.53 percent 1.2 percent. During the same period, the Australian dollar declined from 1.056 against the USD to 0.728 against the dollar.
• The exchange rate bottomed in August around 0.69
• However, there has been divergence since then. Between now and the summer of 2015, the RBA reduced rates further by 50 basis points, while Fed raised rates by 100 basis points. The yield spread also declined from 120 basis points to just 46 basis points. However, the AUD/USD didn’t make further low, instead, it has moved higher from 0.728 in July 2015 to 0.795 as of today.
• We believe, that expectations of a rebound in commodities as well as Chinese economy are playing parts here. However, sooner or letter the due would have to converge, which we expect would come in terms of rate hikes from RBA and increase in the spread in favor of the Australian dollar.

As expected, since our last review in July, the yield spread has started widening in favor of the Australian dollar. The spread is currently at 49 basis points, and the exchange rate is at 0.795. A further correction in Australian dollar likely or the widening of spread.

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