What drives the Australian dollar?
What drives the Australian dollar?
This is the question that bugs the Reserve Bank of Australia every day in terms of forecasting inflation, understanding the consequences of changes of its cash rate and making decision about foreign exchange market intervention. This question bothers me and you when decide trading AUD/USD currency pair. The question is probably more tangible and vital for the Australians whose purchasing power is heavily dependent on the value of Aussie. We won’t lay bare the secret if we tell you that the exchange rate of AUD/USD engrosses the brightest economic minds for decades.
In this article, we explore the traditional and sophisticated fundamental determinants of the AUD/USD exchange rate, with the focus on the latter ones.
Among the traditional fundamentals determining the exchange rate of the Australian dollar, the following should be mentioned:
Monetary policy measures of the RBA (the change in interest rates, e.g)
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Here we must admit that the RBA’s officials are quite conservative and moderate fellas; they are not used to repetitive interventions in the currency market, neither they are famous for frequent changes in their monetary policy stance.
Interest rate differentials
It is one of the biggest factors affecting AUD/USD. Traders or investors chase for a return on investment. An interest rate is a return on money held in deposit. So long as Australia’s official cash rate (currently 1.5%) stays materially higher than the US Fed’s rate, Australian deposit will be more attractive for investors, and they will buy Australian dollars in order to take advantage of the existent yield differential. And a higher bid for currency pushes its price higher.
Small digression from the topic for your info: trading to collect positive interest rate differentials is called carry trading. Carry traders sell a certain currency with a relatively low interest rate and uses the funds to purchase another currency yielding a higher interest rate. For example, in case of AUD/USD, if you place a buy order, you will be paid on the interest rate differential daily (you will receive an interest rate difference – 0.75%) for as long as you are holding the pair. In contrast, if you place a sell order on AUD/USD, your broker will charge you this rate difference daily until you close your selling position.
Fiscal policy measures, undertaken by the Australian government
Government announcements of the planning fiscal cuts, additional spending.
An introduction of broader tax reforms and other expansionary fiscal policy measures initially leads to the depreciation of the currency. But if the central bank expresses its immediate readiness to raise rate in response to the heightened inflation rates, the announcements of the loosening fiscal policy changes coupled with the bank’s commitment to offset the negative effects of such policies on the inflation and exchange rate of the nation’s currency foster the nominal exchange rate of the given currency.
Current account paucity
The current account includes detail of trade transactions of Australia with its trading partners and reflects the payments made to and from abroad. Deficit balance in the account indicates that Australia spends more than it earns on foreign trade, and it is negative for the exchange rate of AUD. Accordingly, a surplus balance in the account leads to the appreciation of Aussie.
As a rule of thumb, an appreciation of the Aussie means a deterioration of the current account (imports become cheaper, this puts exporters at a disadvantage).
Commodity prices, palmy days in the economic activities of China, India
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A rise in export commodity prices implies higher expected returns for Australian exporters. Commodity prices constitute a great share of Australian export. Higher US dollar-denominated receipts for the exported commodities mean greater demand for AUD pushing the currency upwards. So, to unravel the future path of Aussie you should keep an eye on the iron ore, steel prices, grains. Along this line, the strength of AUD is tied to its exposure to Asian countries and their commodity cycles. A higher demand for commodities in China, India, the busts of their industrial activities push the Aussie higher.
Bond spreads
Government bond yields is an excellent indicator of the overall direction of the country’s interest rates. For example, in case of the US, a rising yield on the 10-year Treasury note is dollar bullish. The same can be said in relation to the Australian government bonds.
The spread of both bond yields can be used to gauge currencies. The general rule is that when the yield spread is widening in favor of a certain currency, this currency appreciates against its counterpart. In simple terms, the currency with the higher bond yield appreciates against the currency of the country with the lower bond yield.
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The Australian dollar is especially strong in times of the high net immigration. It is OK to ask why because sometimes economic logic is really twisted, needs an explanation. A high rate of net immigration tends to fuel domestic demand. And significant upticks in domestic demand make Australian assets more attractive to foreigners. This, in turn, is captured in the interest rate differentials. It’s a very complex logical path as you may notice. And there is another factor – heightened rates of immigration are usually associated with large capital inflows as migrants take capital with them to settle, to purchase a house.
Now, we suggest you turning to more subtle correlations of the range of macroeconomic fundamentals with AUD/USD exchange rate which are often not covered by even topnotch FX market analysts.
The interaction between stock prices and exchange rates
Canadian researchers with the help of the tools of econometric analysis found a positive cointegration relation between the AUD exchange rate and stock prices. In their paper, they sought to test the degree of interaction between stock prices and exchange rate fluctuations in Australia in the period of 2003 – 2006. In this period, the exchange rate of Aussie appreciated by as much as 32%, pretty much the same can be said about the Australian stock prices that rose by two-thirds. With the help of Granger-causality test, researchers proved that there is a positive long-term correlation between the AUD exchange rate and Australian stock market. To reassure ourselves in the existence of this correlation we looked at the following chart and found it!
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XAU/USD and AUD/USD
Researchers from the Western Australian School of Mines and Curtin U investigated long-run relationships between the XAU/USD and AUD/USD exchange rates and found out that there is the intercorrelation, bi-directional causality between these two variables. This means that AUD/USD and XAU/USD tend to mean in the same direction. So, to unravel the future path of Aussie you can glance at the direction of the gold prices.
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