After holding the cash rate at elevated levels for the better part of two years, the Reserve Bank of Australia has started to move. With inflation gradually returning toward the target band and economic growth softening, the RBA has signalled — and begun delivering — interest rate cuts in the second half of 2025.

For anyone who watches the Australian dollar, this matters. A lot.

The Textbook Relationship

In theory, the link between interest rates and currency values is straightforward. When a central bank cuts rates, the return on holding that currency falls. International investors seeking yield may shift capital elsewhere, reducing demand for the currency and pushing its value down.

This is the standard channel through which rate cuts weaken a currency. And for the AUD, which has historically been sensitive to interest rate differentials — particularly the gap between Australian and US rates — the relationship has held reasonably well over time.

But Theory Is Not the Whole Story

Markets are forward-looking. By the time the RBA actually cuts, much of the move may already be priced in. If traders and investors have spent months positioning for lower Australian rates, the announcement itself can produce a muted reaction or even a rally if the cut is smaller than expected.

This is exactly what played out in mid-2025. The AUD weakened in anticipation of the easing cycle, but when the first cut arrived, the reaction was modest. The market had already done its work.

What matters more than the individual cut is the trajectory. How far will the RBA go? How fast? And critically, how does the Australian easing cycle compare to what other central banks are doing?

The Interest Rate Differential

The Australian dollar does not trade in isolation. Its value is always relative — to the US dollar, the euro, the yen, and other currencies. So the RBA’s actions only matter in context.

If the RBA is cutting rates but the US Federal Reserve is holding steady, the interest rate differential narrows in a way that typically weighs on the AUD. If both central banks are cutting at similar speeds, the impact on the exchange rate may be smaller.

In late 2025, the picture is mixed. The Fed has been cautious about its own easing path, keeping US rates relatively high. This has supported the US dollar broadly, and it means that RBA cuts are widening the rate gap in a way that puts downward pressure on the AUD/USD pair.

What It Means for Households

For everyday Australians, rate cuts are generally welcomed — particularly by mortgage holders on variable rates who have been under significant financial pressure. Lower rates mean lower repayments, more disposable income, and some relief for household budgets.

But the currency effect works in the opposite direction. A weaker AUD means imported goods become more expensive. Electronics, clothing, fuel, and many food items have an import component, so a falling dollar can offset some of the benefit of lower mortgage payments through higher prices at the checkout.

This is the balancing act the RBA must manage. Easing too aggressively risks reigniting inflation through the exchange rate channel. Moving too slowly risks an unnecessarily deep economic slowdown. The board’s communication suggests they are acutely aware of this tension.

What It Means for Businesses

For exporters, a weaker AUD driven by rate cuts is broadly positive. Australian goods and services become cheaper for overseas buyers, supporting demand. The mining sector, agriculture, education services, and tourism all stand to benefit.

For importers, the calculus flips. Higher input costs, tighter margins, and difficult decisions about whether to absorb costs or pass them on to customers. Businesses with significant import exposure should be reviewing their currency hedging strategies now, not waiting until the dollar has already moved.

The Outlook

Consensus among economists is that the RBA has room for further cuts in early 2026, though the pace will depend on incoming data. Inflation readings, employment figures, and global conditions will all influence the board’s thinking.

For the AUD, the key variable remains the rate differential with the US. If the Fed begins its own easing cycle in earnest, the pressure on the Australian dollar could ease. If the Fed stays put, the AUD is likely to remain under pressure.

Currency markets reward those who pay attention to the data rather than the headlines. The RBA’s rate decisions are important, but they are one input among many. Watching the full picture — domestic data, global conditions, commodity prices, and risk sentiment — gives a far better read on where the dollar is heading.

As always, the AUD will find its level. The question is whether you are ready for where that level ends up.