Where next for the Australian dollar?

SYDNEY (Market Watch) — The Australian dollar has survived a drop in commodity prices and lower interest rates this year, but will the world’s fifth-most-traded currency head lower in the new year? 

The “aussie”— which accounts for around 7% of global foreign-exchange trade — presently trades well over the $1.05 mark, near where it started the year. 

Relatively high domestic interest rates, a triple-A credit rating and an outperforming economy have laid the foundations for the currency’s strength over the last few years, after it started 2009 at around 70 U.S. cents.

It stumbled mid-year to as low as 96 U.S. cents, when a drop in commodity prices raised questions about the future strength of Australian exports, and downward pressure on interest rates eroded some of its yield advantage against rivals. 

Since then, however, iron-ore prices are off their worst levels, thanks to signs that China’s economy is stabilizing, and while interest rates are still well above levels found in many other developed world economies. But analysts say these issues alone don’t fully explain the recent revival in the Australian currency’s fortunes. 

“The simplest answer is that some other factor matters more, and the likely candidate is the risk-on/risk-off dynamic,” HSBC currency strategists said in a recent research note.

“Even a cursory glance at the evidence suggests a strong and consistent relationship between the Australian dollar-U.S. dollar pair and the performance of the U.S. equity market, in turn a reliable proxy for the wider risk-on/risk-off phenomenon,” the strategists said. 

From 2009, the Australian dollar’s rate against the U.S. currency has shown a more than 75% correlation with moves in the S&P 500 according to HSBC’s research. 

Fed matters

Risk-on/risk-off trading in the last few years has in itself largely resulted from massive central-bank liquidity injections into financial markets, where the sheer weight of money has created its own trading force. Money has found a home in many assets, pushing prices up. 

One of the banks leading the way in quantitative easing has been the Federal Reserve, which has had something of a knock-on effect on the U.S. dollar’s performance against rivals such as the aussie.

After their initial push following the 2008 global financial crisis, the central banks again ramped up policy-support measures and liquidity in the latter part of this year, with the Fed recently pledging billions more a month to support the U.S. economy, giving fresh legs to the Australian dollar. 

The Australian dollar “is still being influenced by global factors,” said Alvin Pontoh, currency strategist at TD Securities, who has an end-2013 target of $1.03 for the aussie. 

Pontoh believes the Fed is likely to extend quantitative easing at least to the end of next year, and the European Central Bank will also likely cut interest rates further.