Australian dollar back on the rise

The Australian dollar (AUD) is once again rising. After a sharp spike lower in the wake of the late February market turmoil, AUD rebounded sharply against the US dollar (USD) to the point where it looks set to head towards levels last approached in 1990. As the market has gradually returned to risk loving, the AUD has stood to benefit more than most other currencies.

Observing the price action around the recent Royal Bank of Australia (RBA) rate announcement best illustrates the market's renewed faith in the AUD. Prior to the decision, the market was effectively split down the middle. Twelve of 25 economists surveyed by Bloomberg cited a 25 basis points hike to take interest rates to 6.5%, while the other 13 were looking for unchanged rates.

Whichever way the RBA ultimately decided to go, sizable elements in the market would inevitably be left disappointed. In this context, the rate announcement was seen as a pivotal event for shaping the near term path for the AUD.

In the event itself, the RBA chose to leave rates unchanged at 6.25% - an outcome that one might expect to have immediate negative implications for the AUD, considering the prior speculation for a hike.

Indeed, the knee-jerk reaction was a sharp move lower in AUD-USD. However, after this initial move, AUD-USD soon bottomed out, before eventually reaching levels higher than those seen before the rate announcement. The market seemed to brush off their disappointment with apparent ease.

For a currency that is so often cited as a key beneficiary of the carry trade, it seems perverse that AUD should make gains on the day of a disappointing rate decision for some. However, it soon becomes clear that while the RBA announcement did dampen market rate expectations, this was not to any great extent.

Looking at the movement of expected Australian interest rates, although these did move down following the unchanged decision, they remain considerably higher than has been the case in the rest of 2007 and, notably, above current rates. Evidently, the market believes the RBA may still raise rates in the coming months.

In the second half of 2006 concerns over the somewhat sluggish performance of the housing and retail sectors in Australia had limited the upside for AUD. However, with substantial upside surprises in February building permits and retail sales data, the outlook is once again looking rosy.

The strength of the Australian labour market continues to provide support and, if the recent pick-up in the data persists, then there is no reason to dismiss further RBA tightening. On this basis, further AUD gains look set for the time being at least.

However, that is not to say that they are sustainable on a longer term basis. The late February drawdown provided an important reminder of the influence of current account deficits on a currency. In times of risk aversion, countries with substantial deficits, such as Australia, begin to look very vulnerable.

No matter what the rewards on offer in terms of yield, the structural imbalance still poses significant downside risks for AUD in the future.

Some may point to the recent price action in the AUD as proof that any such drawdown on the basis of structural concerns is likely to be a temporary phenomenon. This means that as soon as the market settles back down, the status quo will be restored.

With AUD once again scaling the heights, this view may have some credibility. However, it would be somewhat naïve to suggest that AUD could continue to perform in such a stellar fashion over the long term.

The RBA's February Statement on Monetary Policy made the point that "the growth in import volumes is likely to partly reflect the upward drift in the real exchange rate". Although it is by no means the most strongly worded discussion of the currency, it highlights that the issue is not far from the minds of the RBA.

Trade weighted measures of AUD are now at historically elevated levels. The risk of a harder line currency stance from the RBA is a significant threat to the AUD going forward.

Evidently, longer term risks for the AUD seem to lie to the downside. However, as the RBA also highlights, there are factors that could limit the currency's impact on Australia's current account position.

Commodity prices, a significant offset for growing import volumes in Australia, are expected "to remain at historically high levels" in 2007. It is believed that the global demand for commodities is not as dependent on the US as was once the case. Instead, growth in the emerging economies, such as China, should keep commodity prices afloat.

With exports of commodities such as coal making up a substantial portion of total exports, buoyant export prices could keep the current account deficit contained. This looks likely to provide the AUD with vital support.

The recent market turmoil certainly appears to have settled for the time being. With cyclical indicators looking impressive once again and the positive outlook for commodity prices, there are significant reasons for a bullish AUD, albeit tentatively, in the nearer term. However, that does not mean investors should not continue to be on their guard.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.