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Analyst report
Fundamental reasons for a record high Aussie dollar against the greenback
March 5, 2008
Brendon Lau, ShareAnalysis
Currency is said to be the most democratic market, as no one player is believed to have the ability to move prices due to the size of the market and no (or very little) inside information exists. However, currencies are also one of the hardest instruments to trade because of the vast array of macro economic factors impacting on the market.
One of the most visible factors impacting the Australian dollar has been inflation. Whenever a report comes out showing that inflation is drifting upwards, our dollar seems to strengthen against the US dollar. For those who took economics 101, this might sound counterintuitive, as inflation normally erodes the value of the domestic currency.
However, because central banks, including the Reserve Bank of Australia (RBA), tend to raise domestic interest rates when inflation gets uncomfortably high, any hint of an outbreak of inflation usually sends the local currency higher.
But there are many other factors that drive currencies. Since currencies are always traded in pairs (e.g., AUD/USD, AUD/Yen, etc.), just looking at Australian economic data can be very misleading. Other than inflation, another closely watched piece of economic news is Gross Domestic Product (GDP). Generally, if a country's GDP grows too strongly, it could trigger a rise in inflation down the track. This is because high demand for goods and services usually applies upward pressure on prices, and vice-versa.
Unfortunately for the US Federal Reserve (Fed), this is not always the case. Recent US data paints a bleak picture for economic growth, including inflation risks. This creates a conundrum for the Fed. If it cuts rates to help save the economy, it would risk sparking higher inflation.
The situation stands in sharp contrast to Australia, where the RBA is threatening to raise rates in an effort to slow economic growth. Right now, the market is betting the Fed will cut rates, while the RBA will raise its target cash rate. The interest rate differential between the countries looks set to widen further, and that is the primary reason why our dollar has risen sharply against the greenback.
Other factors impacting currencies include government budget and the balance of trade. If the government budget shows a widening in the deficit or decreasing surplus, that may be negative for that country's currency as it means the country is spending more than it is making.
The balance of trade is the difference between the value of exports and imports. While Australia has a balance of trade deficit, an increasing value of Australian exports would normally be favourable for the Australian dollar. This is why high commodity prices are supportive of the Australian dollar and the expected price rises for iron ore and coal are likely to lend additional support.
If only things were so simple though. There are also psychological factors that could impact the market. Rising risk aversion is one example. Risk-shy investors have pared carry trade activity since the subprime meltdown, which has led to the sell-down of the Australian dollar against some other major currencies.
The factors outlined in this article are hardly exhaustive, but should give you an appreciation of some of the important drivers affecting our dollar today and explain why some currency analysts are predicting further gains for the Australian dollar against the US currency.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this edition of CompareShares:
Rate rise: When and where will the rate hikes stop
Resident Trader: The greater fool theory of trading shares
Stocks: Good conditions for Newcrest Mining bodes well for its share price
Investing: Top places to stash your cash
Forex: Fundamental reasons for a record high Aussie dollar against the greenback
Expert Panel (CFDs): Capitalising on price movements in reporting season
Housing: A dozen reasons for housing stress
Rate rise: RBA on inflation 'red alert'
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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