Why the interest rate divide between Australia and the US matters

The RBA could soon charge higher interest rates than America for the first time in over two decades, creating unprecedented opportunities and risks for investors.

Make no mistake, the outlook on interest rates for the US and Australia is diverging rapidly and could start to turn in favour of the Australian dollar and the US sharemarket as soon as February.

With the US Federal Reserve cutting interest rates again and the Reserve Bank of Australia holding steady this week, the key short-term interest rates used to set monetary policy are effectively now at 3.6 per cent for both countries – the first time they’ve been the same since December 2024.

That hasn’t moved the dial as yet, partly because a number of economists are now thinking that US interest rates have bottomed, while many still think Australian interest rates have further to fall.

But February 2026 is when it may get interesting.

Over the next two months there is a stack of key economic data to come in the US and Australia on jobs and inflation. Based on current trends, the money market starts to see a chance of the Fed funds target rate falling below the RBA cash rate target in February.

The Fed funds rate target hasn’t been below the RBA cash rate target since December 2000.

With the RBA now expected to hike by 50 basis points over the next 12 months and the Fed expected to cut by 50 basis points, a significant 100 basis points gap may open in favour of the US.

While the RBA cash rate target was as much as 50 basis points below the Fed funds rate at times in the late 1990s, a 100 basis point differential in short-term interest rates in favour of the US hasn’t been seen at any time in the inflation-targeting era that started in the early 1990s.

Of course the money market isn’t currently assuming that US President Donald Trump’s new pick for Fed chair and any other appointments will cause US interest rates to go lower than they would otherwise go. But that assumption could be tested when the new chair takes the reins in May.

When forecasting the Australian dollar, analysts focus on various parts of the yield curve as well as the global risk appetite and commodity prices. But in other things being equal, a significant positive “carry” for the Aussie dollar should put it on an upward path versus the US dollar.

If the Aussie dollar rises sharply enough it could eventually reduce “imported” inflation enough to lower the Reserve Bank’s inflation outlook and reduce any need for it to lift interest rates.

It would also tend to hurt the Australian dollar earnings of companies that report in US dollars.

It would lessen demand for Australian exports, thereby slowing the economy.

And it would also potentially help the profit margins of Australian importers.

US Federal Reserve chair Jerome Powell. Picture: Getty Images

Overall the US sharemarket may get a tailwind for earnings and valuations if the Fed keeps cutting interest rates, but if the Australian dollar is set to rise, those buying US stocks will need to hedge.

The tone from the two central banks this week could hardly have been more different.

Fed chair Jerome Powell emphasised labour market weakness repeatedly in his press conference, noting that reported payroll growth of 40,000 jobs per month was likely overstated by 60,000.

“That would be negative 20,000 per month,” Powell said.

“A world where job creation is negative, I just think we need to watch that situation very carefully.”

He also played down inflation concerns, saying tariff effects should be temporary.

By contrast, RBA governor Michele Bullock delivered an uncomfortable message to Australian households: the next move in rates could be up, not down.

“The risks to inflation have tilted to the upside,” Bullock said. “If inflation pressures look to be more persistent, then the board might have to consider whether or not it’s appropriate to keep interest rates where they are, or, in fact, at some point raise them.”

She effectively ruled out further rate cuts in the “foreseeable future”, saying: “I don’t think there are interest rate cuts on the horizon.”

The divergence is reflected in economist forecasts. Goldman Sachs expects the Fed to deliver two more cuts to a terminal rate of 3-3.25 per cent. Capital Economics predicts the RBA will start raising rates in February and lift the cash rate to 4.1 per cent by May.

Citi economist Veronica Clark thinks markets are “underpricing risks skewed toward deeper cuts” in the US, while noting Powell “emphasised downside risks to employment over upside risks to inflation”.

The critical test will come on January 28 when Australia’s December quarter inflation figures are released, just days before the RBA’s next meeting in February. If that data shows inflation accelerating again, rather than falling back as the bank hopes, a rate rise could be on the cards.

For Australian investors and businesses, the implications are far-reaching.

A rising Aussie dollar would provide some relief on imported inflation but create headwinds for exporters and resource companies. US shares might look attractive but currency hedging will become essential.

The brief era of falling interest rates in Australia appears to be over. The question now is whether rates simply stay put, or whether they’re heading higher – just as the Fed keeps cutting.