The performance of the Australian dollar (AUD) continues to impress in the light of the ongoing market turmoil. Although volatility has pushed back upwards to levels last seen in 2003, the AUD has continued to perform well, and has pushed back up towards the multi-year highs seen in early last November.
Given its status as a high yielding carry trades currency, with a large current account deficit, one would have expected the AUD to suffer somewhat given rising uncertainty in markets. Carry trades consist of the borrowing or selling of currencies with low interest rates and the purchase of currencies with high rates. However the currency has experienced an enduring run of strength since mid-January and looks set to be pushing higher due to rising yield differentials and continued strength in economic performance.
Yield is still an effective driver of currency performance, and although it has been the lower yield currencies which have performed better recently, when market nervousness calms - even for short periods - the higher yielding currencies start to gain. Because of the 125 basis points of Fed cuts in January and a 25 basis points hike by the Reserve Bank of Australia (RBA) on February 5, the yield differential has now widened to over 400 basis points in favour of AUD over USD. The cash target rate now stands at seven per cent, the highest for 12 years.
The RBA cited inflation as the main reason for the continued tightening as its favoured trimmed mean measure of CPI rose 3.4 per cent year-on-year to December, noticably higher than the upper limit of the target band. However, while inflation may remain on the high side for the coming months, the RBA should now be done with their tightening, as other economic indicators have started to hint that the three hikes of the past six months are starting to have an effect.
Given fears of a global slowdown, economic performance has been strikingly robust over the last six months.
However, the latest data has moderated somewhat. Building approvals fell a considerable 16 per cent month-on-month in December. Retail sales were also a little weaker than expected for December although still up 0.5 per cent month-on-month. While the FX market continues to be driven by the equity markets and general swings in risk aversion/appetite, the data may not count for everything for the moment. However, when the dust starts to settle, the moderating data should start to have some repercussions for AUD.
AUD gained strongly when the Fed cuts rates - not just from a yield viewpoint - but also as equity markets were buoyed and nervousness subsided for brief periods. Our concern is: now that with the large Fed cuts in the price, there is little left to counter-balance any bad news seen in the market.
This leaves risk assets in quite a precarious position as the Fed has already sent in the cavalry and there is little left to sooth markets if we see bad news on the wires.
Meanwhile, the New Zealand dollar (NZD) has followed a broadly similar path to the AUD for some time now and while we had expected the NZD to under-perform relative to its neighbour, the pair has traded sideways since mid-December.
Given that rates have likely peaked in New Zealand, and the economic picture has been slowing for some time, this is the case, but as the AUD, the main concern is that any bad news will not now be balanced as it has so far, by prospective Fed actions, and that riskier assets will suffer.
This report was compiled by the Marketing Department of HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.