Weekly AUD Wrap

July 24, 2011


It has been an interesting week for the Australian Dollar versus the USD – finally breaking out through the top of the last couple of month’s range on the back of hopes for a European resolution as we discussed in Friday’s Piece. I’m not sure what the breakdown of Debt ceiling talks in the US is going to have on currency or other markets when they open on monday but there is a strong chance that the outlook could be turning quite positive for the Aussie if we end up with a benign market environment like the one that prevailed prior to the re-intensification of fears about a Greek default. Indeed, we effectively now have a Greek default and the markets have not melted down, rather they have rallied.

What I want to do today, though, is look at the correlations between the Aussie and some other markets to see just how well it has been holding in over the past couple of month’s relatively weak outlooks in other markets.

Over the past year the Aussies daily correlation with things that have benefitted from QE2 and the so-called risk rally has been very high as you can see in the first column of the Bloomberg correlation matrix table above. Indeed you can see that all the correlations are pretty high with each other.

So you could probably argue, without too much fear of disagreement, that the rising tide lifted all the boats.

But over the past couple of months the tide has receded substantially and each asset has had to keep its self afloat. The table below summarises these same asset markets since May 1 2011 on a daily basis.

You can see in this table that the Aussie has been charting its own course to a large extent, but so has everything else too hasn’t it? Look at the EUR/Gold correlation, for example, in the two tables let alone any of the other correlations or the Aussies correlations.

What does this suggest to me? That in a benign environment where the Fed was pumping in money and the USD was weakening that the common linkage, and thus the strength of the correlations across all these markets, was the USD. Now that the USD has stopped falling, or at least halted its fall, it is for markets to find their own levels, own drivers and own way.

So what does it mean now?

The fact that the Aussie has held up so well suggests that the notion of some sort of rerating that we have been talking about for months here at MacroBusiness must have some resonance. Equally, however, the fact that markets never really tanked means that we are unable to judge the strength or size of this rerating. Is it a weak form where investors will bail out at the first sign of a real global meltdown and push Aussie into 0.80’s or will we just see the short-term pressure come to bear and push it into the high 0.90’s.

But what is behind this rerating?

Clearly there is the China story but also the interest rate differential in the Aussie’s favour is a huge boost.

In a benign, non meltdown environment, where you get a substantial pick up for owning Aussie relative to its “major” currency crosses the pressure is to the upside not the downside – unfortunately for local industry. Traders and investors have always used Aussie as a carry trade.

For example the chart below is the AUD/USD exchange rate mapped against the Aussie 2 year Government bond rate versus the US 2 year government bond rate. It is the excuse real money managers use when buying Aussie as an overweight in their bond portfolios. It is an on off switch and was one of the reasons (remember just one part of the toolkit) the Aussie was weaker back a decade ago as the chart below shows. real money managers had no “excuse”, or need, to go long Aussie to enhance portfolio returns so we had a buying strike from this part of the market.

So even though the spread has contracted it is still a very positive driver of the Aussie at present and I think in a benign environment, if that is what eventuates, will once again assert itself as the Aussie becomes the recipient of flows from other “funding currencies”.

I wish I could be more definitive and as I wrote Friday I would be small long here with the break of the range given my turtle tendencies so it’s not to say I am all bulled up or necessarily or want to  see the Aussie rally because of its impact on local industry. It’s not a break until it pushes through 1.1013 and I do want to see this resistance tested again to see how strong it is. But the reality is that the AUD’s setup is looking more positive – we’ll see how it evolves but as the global market backdrop improves so does the outlook for the AUD.



This blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

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