A narrowing interest rate differential with the US, absent underlying inflation pressures and debt laden households are all headwinds for the Aussie Dollar in 2018.

Rising interest rates in the US and elsewhere are likely to see the gap between Australian and US bond yields narrow, reducing the additional yield available to investors who buy Aussie government bonds and undermining support for the Australian Dollar.

“The AUD remains overvalued, and its carry advantage over the USD is likely to continue to narrow, with the US still leading in monetary tightening into H2 2018,” says Dennis Tan, a strategist at Barclays.

US interest rates have risen steadily by around 100 basis points since 2015, taking the Federal Funds rate to within a 1% - 1.25% range, while the Reserve Bank of Australia has cut the cash rate to a record low of 1.5% and held it there for 15 months.

“Australia’s growth and inflation are likely to remain subdued, given its late-cycle position, the secular adjustment in the commodity sector, and significant internal imbalances,” Tan adds.

Headline Australian inflation came in at 1.8% for September, the most recent month for which data are available, which was below the 2% rate expected by economists. The third quarter wage index rose by just 0.5% when economists had forecast a 0.7% rise.

The poorer than expected pay growth number came despite an increase in the minimum wage during the period and has lead some forecasters to wonder if underlying inflation pressures are weaker than had previously been thought.

“Stretched property prices and household debt levels pose downside risks to construction activity and investments, as well as household spending,” Tan notes.

Household debt levels have been a constraint on the Reserve Bank of Australia, which has said repeatedly that it will not raise interest rate until inflation returns to target and wage growth is sufficient enough to enable households to whether higher borrowing costs.

“Weaker-than-expected wage and employment data out of Australia causes us to stick to our narrative of deteriorating economic conditions as global funding costs rise,” says Gek Teng Khoo, a strategist with Morgan Stanley.

With inflation still below the lower bound of the 2% to 3% target range and wage growth surprising on the downside, the RBA would appear to have little incentive to follow in the footsteps of its international counterparts by raising rates anytime soon.

Regardless, the Reserve Bank may only be able to shield Australian households from rising interest rates for so long.

Monetary policies on distant shores can also have an effect on Australia as borrowing costs will eventually rise on international markets while a weaker currency can also raise the cost of servicing foreign currency debt.

“We are bearish on AUD despite anticipated USD weakness,” says Khoo. “AUD has been sensitive to the US 2y yield, and the upside surprise to US core CPI in October will probably lead to a higher core PCE reading next week, adding to AUD weakness.”

The Australian Dollar has gained nearly 5% on the greenback during 2017 but shed 2% and 7% to the Pound and Euro.

It was quoted 0.25% lower against the Pound Tuesday, placing the Pound-to-Australian-Dollar rate at 1.7575. The AUD/USD exchange rate was marked down by 0.21% at 0.7537.

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