The Australian dollar's altered rules

That sharp little spike in the value of the Australian dollar after the Reserve Bank left official interest rates unchanged today points to at least one of the key factors driving its value but doesn't fully explain its eccentric recent behaviour.

As RBA Governor Glenn Stevens said today, the exchange rate has remained high "despite the observed decline in the terms of trade and the weaker global outlook".

He isn't the only one puzzled by the behaviour of the dollar, given the historical close – near perfect – correlation between the direction of the dollar and commodity price movements. With commodity prices now well off last year's peaks and the prices of bulk commodities down about 30 per cent this year the continuing strength of the dollar represent a significant departure from the conventional wisdom about its behaviour.

BHP Billiton's Marius Kloppers recently expressed his bemusement about the resilience of the currency in the face of the commodity price falls and the weakening growth rate in China's economy. That he finds it confounding isn't surprising because it has been an article of faith within BHP and other miners – and an important element in their financial modelling – that the currency would move in line with commodity prices.

The reaction of the dollar to the RBA's inaction signals that Australia's positive real interest rates are a key factor in its resilience. A real yield from investing in Australian Government bonds of around 2 per cent may not look all that compelling but given that official interest rates in the US and Europe are negative in real terms they are clearly attractive enough to attract big flows.

Exchange rates are, of course, driven by relativities and the real yield comparisons are one of them. The other is that Australia is one of a handful of AAA-rated economies with a very deep and liquid market in its currency – the dollar is one of the more heavily traded currencies in the world. That offers the prospect of an easy and not too painful exit if investors want to shift their funds.

Until relatively recent the dollar was being yo-yoed around by the risk-on, risk-off trading that would see funds flee to the US when perceived risks within the global economy were rising and then deployed in search of positive returns the moment risks were seen to have receded.

Part of the hypothesised appeal of the dollar when risks were seen as ebbing was that it was seen as a safe proxy for China, but the slowing within China and the flow-through of that slowdown to commodity prices doesn't appear to have had much of an impact.

It may be the investors are changing their view of the US as the only safe haven slightly because of the continuing speculation that the US Federal Reserve might embark on another round of quantitative easing, devaluing their funds further.

There have also been reports from market participants of recent buying of the dollar by foreign central banks trying to diversify their reserves into, for them, novel currencies. Any central bank with euro exposures – or indeed any corporate or institution with exposure to the euro – might well consider it safer to own Australian Commonwealth Government Securities.

Indeed, overnight Shell revealed it has shifted most of its cash reserves out of Europe and the euro and into US banks and treasuries. They'd get a better return here.

There is a price to pay for a high dollar. While it helps keep a lid on inflation, which is now below the RBA's target band, and does increase the purchasing power of importers and travellers, it is exacerbating the pressure on the already struggling trade-exposed segments of the manufacturing sector.

Because of the pressure the dollar is exerting on already-stressed sectors of the economy and the misalignment of what appear to be purely financial flows rather than anything to do with the fundamentals of the economy former RBA board member Warwick McKibbin recently advocated RBA intervention to force the value of the dollar down, a call that has been generally dismissed and which would be a novel move by the RBA.

The problem with intervention is that the dollar may well be trading at or around its fair value, given the relativities between the economic fundamentals here and in other major developed economies.

If the RBA did believe the dollar was significantly overvalued to the extent that it did pose a threat to the economy, today's currency market response to its decision to hold rates provides the obvious mechanism for reducing its appeal. It would just need to start cutting official interest rates again.