Australian dollar still going strong

Over the past month, the Australian dollar (AUD) has held on to its gains despite some carry trade (a strategy where an investor borrows in another country with lower interest rates and invests the funds in the domestic market) concerns.

The market is pricing in rate hikes from the Australian Central Bank over the coming year and the impressive Australian labour market performance makes it hard to bet against them. However, if a carry drawdown does emerge, AUD, as one of the most heavily exposed currencies, would feel the pinch along with the other carry currencies. However, strong fundamentals of rising commodity prices and increasing interest rates may see AUD outperform currencies such as the New Zealand dollar (NZD) in either a carry drawdown situation or otherwise.

Given the extensive focus on carry trade, it is unsurprising that rate expectations continue to hold the key for AUD performance. Looking at the relationship between a trade-weighted index of the AUD against interest rate expectations implied by the March 2008 futures contracts published by the Bank of England, one notices that the relationship looks tight at first glance.

As rate expectations have climbed, AUD has been carried along in the wake. Indeed, over the period from June of last year, the positive correlation between daily changes in implied rate expectations and the trade-weighted AUD is significant. So rising rate expectations go hand in hand with a rising AUD. The question now is whether this time around, this relationship will hold water.

One supportive factor is that the recent rhetoric from the Royal Bank of Australia (RBA), Governor Stevens has continued to err on the hawkish side. Speaking recently, he was adamant that risks for medium-term inflation and growth remain skewed to the upside. Statements that it is "much harder to create additional supply" and that stronger domestic demand could lead to "overheating and inflation" certainly seem to be paving the way for a future tightening.

The resilience of the labour market in the face of high interest rates and the recent drought seems to suggest that further tightening may be warranted. In the current tightening cycle, interest rates have increased 2%, yet the unemployment rate is currently still close to 30-year lows at 4.3%. Considering that the worst of the drought is now thought to be over, obstacles facing the Australian economy appear to be clearing. It remains to be seen whether the 50 basis points tightening that the market is currently pricing in for next March will be enough to let the air out of the tyres.

Another factor that is likely to support a higher AUD is the buoyancy of global commodity prices. Over the past year, commodity prices have moved consistently higher. Furthermore, the upbeat outlook for global growth suggests this trend could well be set to continue. Given the sizable portion of Australian exports accounted for by commodities, this may keep the RBA satisfied with AUD strength for now.

In 2006, nearly a third of total Australian exports were accounted for by exports of coal, iron, aluminium, gold and copper. As a result, rising commodity prices have helped to insulate Australian exporters from the potentially negative effects of a stronger currency. Importantly, this may have contributed to the RBA staying quiet about the elevated levels of the currency. The longer the central bank is satisfied with AUD strength, the more confident the market will be in taking it higher.

It is nevertheless important to remember that the reward that AUD offers in terms of yield reflects a considerable degree of risk. While the drought concerns may be easing, there are still potential obstacles lying in wait for the Australian economy and the currency.

Structural concerns are a large blot on the Australian economic landscape. Analysts expect the Australian current account deficit to be a sizable 5.8% of GDP. From past experience, when the market has become nervous about risk, current account deficit currencies, such as AUD and NZD, suffer first and perform the worst. Considering the weight of long AUD positioning in the market, this may work against the AUD.

Global market conditions may therefore dictate the path for the AUD rather than Australian-specific issues. There is also the danger that, while the RBA may want to adopt a tighter monetary policy, other factors may steady their trigger finger for now. Governor Stevens has always been keen to point out that future decisions will be dependent on the upcoming data. For example, it would be much easier for the RBA to announce monetary tightening if the inflation data is looking threatening.

Over the past month or so, the AUD has broken to new 18-year highs against the US dollar, 16-year highs against the Japanese yen, and trade-weighted measures have pushed up to their highest levels since 1991. Technically speaking, the signs are looking good. Moreover, the interest rate backdrop is still supportive and the RBA remains content with currency strength. However, any AUD bullishness must be tempered with some caution. AUD strength will ultimately depend on the general appetite for carry trades.

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.