AUD/USD drops under 0.7000 as USD strengthens amid Middle East war

• AUD/USD breaks under the 0.7000 level and posts a 1.36% decline on Tuesday.
• The US Dollar strengthens sharply, supported by risk aversion linked to the war in the Middle East.
• The RBA maintains a hawkish bias, but this isn't enough to offset selling pressure against the Greenback.

AUD/USD extends its pullback and trades around 0.6990 on Tuesday at the time of writing, down 1.36% on the day, after breaking below the 0.7000 level. The pair is now hovering at multi-week lows, pressured by renewed demand for the US Dollar (USD) and a market environment dominated by risk aversion.

The US Dollar Index (DXY), which tracks the Greenback’s performance against a basket of six major currencies, rises 0.8% to near 99.40, its highest level in more than a month. The US currency benefits from safe-haven flows as the rapid escalation of tensions in the Middle East fuels investor concerns. Comments from US President Donald Trump and Secretary of State Marco Rubio, referring to potential new attacks against Iran, reinforce this climate of uncertainty and underpin the US Dollar’s status as the world’s reserve currency.

In this context, cyclical and high-beta currencies such as the Australian Dollar (USD) remain under pressure. Markets are also trimming expectations of aggressive rate cuts from the Federal Reserve (Fed) this year, amid still-sticky inflation, which helps support US yields and the Greenback.

On the domestic front, the Reserve Bank of Australia (RBA) maintains a clearly restrictive stance. Governor Michelle Bullock stated that a rate hike remains possible as soon as the March meeting if the Board judges that inflation expectations risk becoming unanchored. Markets are pricing in around a 30% chance of a 25 basis point hike in March and fully expect tightening by May, according to Reuters. The RBA stressed that it remains “very alert” to inflation risks, particularly those stemming from higher energy prices in a tense geopolitical environment.

In addition, MUFG notes that higher Australian yields are providing some support to the Australian Dollar (AUD), arguing that the RBA’s hawkish stance helps cushion the energy shock. However, the bank warns that a prolonged bout of risk aversion driven by rising energy prices could ultimately weigh further on risk assets, including the Aussie.

Market attention now turns to Australia’s Services Purchasing Managers Index (PMI) due later in the day, as well as the Q4 Gross Domestic Product (GDP) report scheduled for Wednesday. These releases could provide fresh insight into the strength of domestic activity and help refine expectations regarding the RBA’s policy path. Later on Wednesday, China’s PMI figures may have an impact on the Aussie, given Australia’s strong trade ties with China.