Since the Aussie is often considered the riskiest of the G10 currencies overall market risk can have big implications for AUD crosses. There are a few things that drive the Aussie that is worth looking at in detail at this time: 1, China and its growth prospects, since it is Australia’s most important trade partner, 2, the performance of other risky assets like stocks that tend to have a strong positive correlation with the Aussie and 3, domestic interest rates.
AUDUSD and China
Looking at China first, Australia’s exports of iron ore to China have been picking up of late and the iron ore price recently reached its highest level since 2010. Since September the price of iron ore has risen more than 80%, this is important for FX traders as the price of iron ore and AUDUSD have a strong positive correlation as you can see in the chart below. In recent days iron ore has pulled back from its recent highs, but it remains at an elevated level. The pick-up in the iron ore price is partly down to expectations of a revival in China’s growth this year, thus a lot of good news could already be in the price. Thus we may need to see sustained strength in Chinese economic data for the iron ore price to make another leg higher. From an FX perspective, if the price of iron ore has over-shot on the upside then it could be due a more profound correction that may weigh on AUDUSD in the near-term.
AUDUSD and the SPX 500
The second thing to consider is the SPX 500. AUDUSD also has a strong relationship with stocks, as you can see in the chart below the two tend to move in the same direction. Thus, for AUDUSD to sustain a break above 1.06 we may need to see the SPX 500 extend its rally above 1,500 over the next couple of weeks. The big “risk-on” theme that dominated the start of the year may be losing a bit of steam as we move towards the second half of January, but it is worth noting that liquidity fuelled rallies like this one (2013 saw one of the largest initial inflows into equities in years) often last longer than some of the bulls may think. If we continue to see a re-allocation of assets out of government bonds and into equities then we may see the SPX 500 extend its recent gains in the medium-term if this liquidity is sustained. Thus, at this stage, the equity market looks supportive of a sustained rally in AUDUSD.
Chart 2: AUDUSD and the SPX 500
AUDUSD and interest rates
The last driver I will look at is domestic interest rates. The RBA cut rates in the second half of 2012, and the bank is expected to keep rates on hold at this low level for the next few months at least. The relationship between domestic rates and AUDUSD has broken down, as you can see in the chart below, with AUDUSD being propelled higher by external rather than domestic factors. However, in the first half of 2012 expectations of RBA rate cuts hit AUDUSD, which declined from 1.08 to 0.98 between February and May last year. Thus, we would not rule out that the relationship between rates and the AUD could be re-kindled later this year. But going forward the RBA may prefer not to cut rates in the near future as growth in China picks up and external issues like the Eurozone debt crisis seem to have stabilised. Thus, the AUD could be more sensitive to any signs that the RBA may tighten policy this year, so watch out for hawkish comments from RBA members in the coming weeks and months as this could be supportive of AUD strength.