Chinese demand for commodities like copper, steel and iron ore, and speculation over what the Reserve Bank and other central banks will do with interest rates, are key drivers behind recent Aussie dollar volatility.
A strong currency is usually a sign of a healthy, growing economy. That’s why the AUD generally rallies when the Reserve Bank of Australia (RBA) raises interest rates and conversely dips when there’s a rate cut. Out CLY Financial Adviser Brighton would like to share some knowledge and update about Australian dollar and economy.
A rate hike signals a vibrant growing economy, and typically coincides with good news like strong manufacturing data, positive inflation, falling unemployment and improved retail spending while a rate cut is a tool used by central banks to spur economic growth.
Over the last five years, interest rates in Australia have fallen to a record low of 1.75 per cent, as the RBA strives to make borrowing even cheaper to encourage spending and investment.
There’s speculation that rates may fall further as the Australian economy struggles to transition from mining-led growth to broader-based growth.
The RBA’s May decision to cut rates to 1.75 per cent and keep them on hold in June has seen the value of the AUD slide back against the US dollar (USD), aided by falling commodity prices.
This was markedly different to April when the RBA’s decision to keep rates on hold for the eleventh consecutive month amidst rising steel and iron ore prices saw the dollar rally.
In order to understand the drivers of recent AUD volatility, it’s important to first understand the key drivers of the Australian economy.
The performance of the Australian economy is closely linked to the growth of the mining sectors, which are big exporters to China and the rest of the world. The Australian government depends heavily on taxes from the resources sector.
The Australian dollar is therefore tied to global growth and demand for commodities, which is why it’s commonly described as a “commodity currency”.
China is Australia’s largest export partner but the pace of growth in the Chinese economy is slowing, pushing the country’s central bank, the People’s Bank of China (PBoC), to introduce a range of stimulus measures.
Commodity prices and interest rates are two of the major forces that drive the AUD.
The tug of war over the AUD in the last few months is linked to the price of China-related commodities like steel and iron ore, which have rallied off the back of PBoC stimulus and then fallen, in part due to higher prices resulting in extra supply.
The other important factor is the interest rate differential between Australia and the rest of the world. While Aussie bonds may not be giving investors a real return, at a time when other countries have zero or negative rates, Australian 10-year bond yields look fairly attractive, which is supporting the AUD at the moment.
Despite historically low interest rates, the AUD seems overvalued due mainly to economic instability in other parts of the world. In June, German bond yields dipped below zero for the first time, joining Switzerland and Japan.
The US Federal Reserve’s recent change in tone from hawkish to dovish also provided impetus for a higher AUD. Weak US employment dimmed the prospect of the Fed raising rates again, which saw the AUD edge higher over the potential for the interest rate differential between the US and Australia to narrow.
The differential between Australia and the rest of the world is a factor that may be buoying the AUD, and many investors believe it is currently trading above fair value.
The Australian economy has been relatively resilient until now, with moderate inflation, but there’s a real risk it could also be impacted by the low inflation affecting many other countries.
In terms of volatility, the interaction of commodity prices and interest rates is driving volatility in the AUD, and also the ebbs and flow of risk appetite as the world economy adjusts to a slower pace of growth.
A long term financial plan is designed to withstand volatility across currencies and markets. However, if you wish to find out more information about how currency volatility can impact your investments, please make an appointment to discuss this further with our experienced financial advisers from CLY Financial Planning Brighton.
Please note, all information in this article was compiled in July 2016 and accurate as of the dates stated throughout.
Disclaimer: The information (including taxation) is general in nature and may not be relevant to your individual circumstances. You should refrain from doing anything in reliance on this information without first obtaining suitable professional advice. You should obtain and consider a Product Disclosure Statement (PDS) before making any decision to acquire a product.