Australian dollar: uncertain times down under

Ironically, the Australian dollar (AUD) recently climbed to its highest point against the US dollar for 23 years before falling aggressively. Since reaching that peak, it has fallen sharply as credit market concerns in the US have migrated into wild equity swings.

Emerging from this contagion has been a carry trade drawdown which has had adverse effects on AUD. This fall has come about despite strong Australian macro data throughout, and interest rate hikes by the Royal Bank of Australia (RBA).

It was noted that if a carry drawdown did emerge, then AUD would suffer as one of the most heavily exposed carry currencies. However, there is now more concern that there will be a full-on unwind of the carry trade, which would see AUD take a further beating. The global outlook remains uncertain and the carry situation remains a major risk to the AUD.

In the five days after hitting its 23-year high in July, AUD-USD tumbled back nearly five per cent. This fall was a result of nervousness in the market following the equity market drawdown over the same period. The rise of risk aversion caused people to pull out of their carry trades, and buy back the safer currencies such as JPY and CHF. In these five days, AUD-JPY dropped nearly 6.5 per cent.

In the past, when the market gets nervous about risk, the shift away from currencies with large external deficits has been also notable. This could be a big problem for the AUD.

Australia has consistently been a current account and also a trade deficit economy. The most recent data showed the trade deficit had widened significantly after exports fell three per cent in June. Exports suffered following big falls in metal ores, coal, transport equipment, cereals and meat, with poor weather conditions slowing commodity output.

This suggests that the deficit could rebound soon, though AUD would still be precariously placed even if its external imbalances started to shrink. This is because of the weaker global economic environment, rather than the domestic economy, which has generally been performing well for some time.

Early last month the RBA hiked the cash target rates by 25 basis points to 6.5%. Although stating that it gave "careful considerations to recent developments in the global economy and financial markets", the RBA board feel that the broader global outlook has not changed significantly.

Domestic data had also been pointing towards a rate hike. Inflation has been high and the most recent RBA trimmed mean measure - which the RBA watch most closely - rose by a record equalling 0.9 per cent in the second quarter.

It is not only this record price growth that has concerned the RBA, or that the annual core rate remains stubbornly high at 2.7 per cent. It is that core inflation has accelerated at a time when the economy is producing close to capacity, and there is every likelihood that both demand and output will strengthen over the coming year.

This underlying strength has also been prevalent in the majority of macro data. For example, retail sales figures were well above expectations, as were building approvals and private sector credit.

AUD did initially rally on the back of the rate rise, but global events have dominated its subsequent movement. The market is still more concerned about global economic conditions than the high yield of the AUD. In the face of a possible unwinding of the carry trade, the AUD would be punished.

Although the AUD is one of the principal carry currencies, it may suffer less than NZD. There are two main reasons. First, the economy is fundamentally strong. This in turn leads to the second reason - the RBA is not finished raising interest rates just yet, whereas in New Zealand it appears the tightening cycle is over.

Recently, RBA governor Stevens feared that the "widespread reassessment of risk and a tightening of credit across the US economy" would have the effect of "dampening growth more generally".

However, since then the Australian economy has continued performing unabated and Stevens' comments have become more hawkish. This has given the market the belief that monetary policy will be tightened, and this gives AUD a small edge over NZD.

With carry now looking more and more vulnerable in the face of rising volatility and risk aversion, AUD could well suffer. The only salvation the AUD has is that it may suffer less than its antipodean neighbour.

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.