The Australian dollar has typically been viewed and traded as a risk currency, tracking global risk appetite and commodity prices pretty closely. These typical drivers have broken down over the last six months, especially the previously strong correlation between the Australian dollar and commodities prices, and in particular the bulk commodities like iron ore and coal.
Despite the big fall in bulk prices over the last six months the Australian dollar has remained stubbornly high. There are a number of reasons why foreign capital is flocking to the Australian dollar.
First the Australian dollar has been viewed as a pseudo safe haven currency. This is largely due to the well-publicised financial problems in Europe and the US, which make the Australian dollar look very attractive and stable on a relative basis. The ratings of the big four Australian banks relative to international peers also means foreign investment is flooding into the these key stocks which puts further upward pressure on the Australian dollar.
On top of this, the economic conditions in Europe and the US have resulted in very low interest rates. For any investor looking to earn a real return (a return above the rate of inflation), they have to look far and wide. A cash yield of 3.5 per cent and some stock yields north of 5 per cent has made investing in Australian assets very attractive indeed.
These factors create a large demand for Australian dollars, hence the reason it is still trading well above parity.
So what is the outlook over the next few months? As concerns over the state of affairs in Europe and the US ease, as they have done most recently, we should theoretically start to see some money flow out of the Australian dollar as investors switch safe haven assets for riskier asset classes like international equity markets.
On the flipside, an increased appetite for risk assets like commodities and equities has historically been positive for the local currency. It will be very interesting to see which theme proves stronger as it will likely set the direction in the coming months.