Expanding Aust/US rates gap underpinning $A volatility

An expected widening of the gap between official interest rates in Australia and the US could herald a period of instability for the Australian dollar.

The relationship between exchange rate volatility (technically, the annualised standard deviation of daily changes) and interest rate spreads is not cut and dried.

At times, notably between the Australian dollar's float in 1983 and the early 1990s, the gap between the overnight cash rate set by the Reserve Bank of Australia (RBA) and the fed funds rate set by the US Federal Reserve appeared to move in close parallel with the exchange rate.

Not only did a wide interest rate gap tend to coincide with periods of economic anxiety - such as the commodity price collapse of the mid-1980s, but the interest rate gap tended to create its own volatility by attracting "hot money" from international investors.

They flocked to high-yielding Australian money market instruments, causing the currency to creep ever upward.

Then some adverse economic news or speculative selling would be the catalyst for a sudden fall to a more realistic level, the so-called "up by the stairs, down by the elevator" pattern.

The relationship was not so clear-cut from the early 1990s, as investors adjusted to the new low-inflation, low-interest rate environment cemented by the RBA's announcement of its two to three per cent inflation target in early 1993.

And there were volatility spikes unrelated to interest rate differentials.

In the late 1990s, for example, unease over the Russian debt default and the collapse of the Long Term Capital Management hedge fun in 1998 boosted volatility, as did the terrorist attacks on the US in September 2001.

But the earlier tendency of volatility to move in sync with the interest rate gap seems to have surfaced again.

The widening of the interest rate gap from around zero in 2000 to a high of 425 basis points (4.25 percentage points) in early 2004 was associated with a lift in volatility comparable with the highest peaks over the previous 20 years.

The subsequent narrowing of the interest rate gap to just 50 basis points in mid-2006 coincided with a decline in volatility.

Over the year to July 2007, with the sub-prime loans crisis yet to blow up and the Australia-US interest rate gap at a relatively skinny 100 basis points, the Australian dollar was as stable as it had been for a decade.

However over the half-year since then the currency has been more volatile than in any six-month period since 1985.

The sub-prime loans crisis, the associated wild fluctuations in the share market can take some of the blame for this.

But the wider interest rate gap may also be part of the explanation.

With a drawn-out series of interest rate hikes from the RBA bringing the cash rate to 6.75 per cent by November and the US Fed's more recent cuts taking the fed funds rate to 3.50 per cent, the differential has expanded to 325 basis points.

The Fed's policymakers (the Federal Open Market Committee) begin a two-day meeting in the US on Wednesday to decide on a likely cut to 3.00 per cent.

The futures market is tipping further cuts to 2.25 per cent by early in the second half.

At the same time the market is anticipating another quarter per cent hike from the RBA, to lift cash to 7.00 per cent by around mid-year.

Those prospective moves would put the rate gap at 475 basis points, its widest since 1991, in other words a new high for the low-inflation era, increasing the likelihood of a period of intense volatility for the Australian dollar.