Why is the Aussie dollar so strong?

Australian productivity has gone backwards since 2019. Unit labour costs are running ten points above the United States from a common base. The goods trade balance in trend-terms has fallen from above 13 billion dollars a month at the 2022 peak to barely 3 billion, with the latest print briefly negative. Inflation has reaccelerated above the target band on every measure. By any fundamental read, the Australian dollar should be weakening. It isn't. It has rallied from briefly below 0.60 last year to above 0.72 now and the trend is looking up.

The answer is the carry. Everything else is detail.

Inflation is going the wrong way

The disinflation has stalled and reversed. Every measure of Australian CPI is now above the 2 to 3 target band, and every measure is rising. Monthly headline is 4.5. Quarterly headline is 4.0. Trimmed mean and weighted median are at 3.5. The direction is up across the board.

This is why the cuts camp has gone quiet and the hold-or-hike camp has the floor. Inflation reaccelerating above the band is straightforward enough that nobody is seriously arguing for easing into it. The RBA has hiked three times this year and is more likely to move again than not, probably after a meeting or two of pause to assess the lags.

Productivity has gone backwards

Part of the reason the disinflation has stalled is structural. Australian whole-economy labour productivity sits below its 2019 level. American productivity over the same period is up nearly twelve percent. Both economies were tracking similar trends before the pandemic. The gap has opened entirely since.

On the cleaner market-sector comparison that strips out the public sector, Australia has barely held its pre-covid trend while the US has broken meaningfully above its own. The divergence is real on either measure.

   

Unit labour costs are the inflation mechanism

Australian unit labour costs are up nearly thirty percent from a 2019 base. American unit labour costs are up twenty. The gap is ten percentage points and widening. American wages have grown faster than Australian wages, but the productivity gap is so large that Australian unit costs are still climbing faster than American ones.

This is where the inflation comes from. Wages don't have to be high in absolute terms to be inflationary. They just have to outrun productivity. Australian productivity has gone backwards. So even modest wage growth becomes a cost-push impulse, and that impulse keeps feeding into services prices. Monetary policy can compress demand. It cannot fix a supply side that has broken.

The external position has collapsed

The same cost-side story shows up in the trade numbers. The trend in Australia's monthly goods trade balance has fallen from above 13 billion dollars during the 2022 commodity boom to around 3 billion now, with the latest monthly print turning negative for the first time in years. The direction is unambiguous and the trend line is still pointing down.

The current account, which combines trade and income flows, has deteriorated to a quarterly deficit of 21 billion dollars, the worst reading in twenty years. A country running this kind of external deficit has to fund it with capital inflows. Those inflows currently come on the basis of yield, not on the basis of underlying export strength. The AUD is being held up by money that wants the RBA policy rate, not by money that wants Australian goods. That is a less stable foundation than it looks.

The curve and the differential

The Australian ten-year government bond sits at 5.07 percent. The US ten-year is at 4.46. The spread is 61 basis points in Australia's favour and widening. The long end is where mortgages, business investment hurdle rates and government debt servicing price, and it is running well above the cash rate.

On the front end, the Federal Reserve has eased to 3.64 percent. The RBA has held at 4.35. Australia is now running 71 basis points above the United States on policy rates. For most of the past decade the two rates moved together. The current divergence is unusual, and given sticky inflation in both economies, more likely to widen than to close.

   

Which brings us to the dollar

The AUD has competing pressures. The structural picture argues for a weaker currency: productivity below 2019, unit labour costs ten points above the US, goods trade balance in deficit. The textbook says these forces should pull the currency lower.

They are not. The carry is doing the work. With the RBA at 4.35 and the Fed at 3.64, the ten-year spread at 61 basis points and widening, and inflation rising in Australia on every measure, the rate differential is supporting the currency in defiance of the fundamentals. Strip out the carry and the AUD has very little going for it.

That makes the AUD outlook largely a question about central banks rather than about Australian fundamentals. With the RBA more likely to hike than cut and the Fed unlikely to ease aggressively into sticky US CPI (and perhaps even raise), the differential is more likely to remain unchanged or widen than to compress in the near term. There is probably still some life in the carry trade over coming months.

The asymmetry

The structural drags compound while the carry holds the price. Each quarter, the productivity gap widens, the ULC gap widens, and the cost-push inflation impulse keeps feeding through. With the RBA likely to add to the three hikes already delivered this year, the rate differential strengthens, the curve tightens further, and the AUD stays supported even as the underlying competitiveness picture deteriorates. The longer the carry suppresses the currency adjustment, the more pressure builds for the eventual move. When the carry support eventually fades, the adjustment is likely to be larger than it would have been if the price were already reflecting the fundamentals.

This is not a near-term short. The carry is doing the work and is more likely to strengthen than weaken from here. But it is the wrong currency to be long for the long run. The fundamentals are deteriorating, the inflation problem is partly structural and outside monetary policy's reach, and the support is contingent on a rate differential that itself reflects two central banks unable to ease into their respective inflation problems.

So why is the Aussie dollar so strong with productivity this weak? Because the carry is paying you to ignore the fundamentals. That works until it doesn't, and when it stops working the move is bigger than it would have been if the fundamentals had been getting a hearing all along.