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  • AUD/USD is off highs but still trades with decent gains on the day as markets continue to bet on higher inflation ahead.
  • The Democrats appear to have won control over Congress, meaning more fiscal stimulus is likely incoming.
  • Commodity-linked AUD stands to benefit from higher inflation.  

AUD/USD rallied above the 0.7800 level early on during Wednesday’s European morning session, hitting multi-year highs at 0.7820 by around 10:00GMT, but has since fallen back to trade around 0.7770 amid a mild recovery in the US dollar that has seen the Dollar Index (DXY) recovery back to 89.70 after hitting multi-year lows in the 89.20s in early European trade.

The pair still trades with marginal gains of around 0.1% or just over 10 pips on the day, however, and is one of the best performing USD major pairs on the day alongside NZD/USD, which up by over 0.4%. Commodity-export exposed currencies AUD and NZD seemingly continue to benefit from reflation hopes that have been boosting commodity prices across the board as of late.

A softer than expected US ADP National Employment number was ignored by the US dollar, even though it does not bode particularly well for Friday’s official jobs report. ADP estimated that 123K Americans lost their jobs in December 2020 versus expectations for an estimated gain of 88K.

Markets are more forward-looking than usual right now, however, after victory in the two Georgia Senate elections handed the Democrats control over Congress. That means more fiscal stimulus ahead, so markets are likely to look through any Q4 2020/start of Q1 2021 economic weakness in anticipation of stronger growth later in the year.

Inflation expectation boosts helping the commodity-exposed Aussie

Inflation expectations in the US received a boost in wake of a surprise Democrat sweep in Tuesday’s two Senate elections which has handed the left-leaning US political party control over the US Congress. Control over Congress means the Democrats will be able to more aggressively pursue their economic agenda which includes 1) significant further fiscal stimulus including aid for states and local governments and further direct payments, 2) higher taxes on business and high-income earners and 3) tougher regulations on big Tech and the energy sector.

US 10-year break-even inflation expectations rallied as high as 2.07% on Wednesday, up from the low 1.9%s at the end of 2020, with fiscal stimulus expected to boost the US economy and push up commodity and consumer prices. As noted above, commodity-linked currencies such as AUD and NZD stand to be amongst the greatest beneficiaries of this in the G10.

Debate on how a Democrat-controlled Congress will impact USD

Bullish arguments

  • Higher government spending will boost US bond yields and then eventually also the US economy in 2021 relative to its peers, increasing the relative attractiveness of the US dollar versus some of its major lower growth, lower-yielding peers (such as EUR, GBP and JPY).
  • Higher US growth in 2021, and perhaps a faster than expected pick-up in inflation, might encourage the Fed to wind down its asset purchase programme sooner than markets are currently pricing, which could see US real yields rising, a USD positive.
  • Congress will now be able to undo US President Donald Trump’s tax cuts on corporations and the wealthy may hike taxes in other areas and are likely to pursue tougher regulations on big Tech and the energy sector (as the Biden administration pursues climate goals). This might well be an equity market negative on balance, which might support safe-haven assets such as the US dollar.

Bearish arguments

  • The faster US economic recovery in 2021 will be driven by US government deficit spending, which will further worsen the US government’s fiscal position and put further upwards pressure on the US’ already historically large trade deficit, factors that could both put downwards pressure on the US dollar.
  • As US national debt balloons under a Democrat-controlled Congress, the Fed will face greater pressure to keep monetary conditions accommodative so that the increasingly indebted US government can actually afford to continue to service its debt. The country’s higher debt load will make it more difficult to eventually raise rates down the road.
  • Given the above-mentioned difficulties the Fed will face in raising interest rates (i.e. not wanting to risk the solvency of the US government), combined with its recently announced average inflation targeting policy (that means the Fed will be willing to tolerate above-target inflation for a time), the Fed is likely to be “behind the curve” in combatting rising inflation (if inflation was to return faster than expected).
  • It’s looking more and more likely that the Fed is going to have an inflation problem, given the recent surge in commodity prices and inflation expectations. If (or when) this starts to show up in the hard data, Fed indifference to inflation risks might pressure the US dollar.