The phenomenal force driving the Aussie dollar

One of the more curious developments since the global financial crisis developed has been, not just the volatility in the Australian dollar and our financial markets, but the unusual patters of their behaviour in response to developments offshore.

Today there was a sharp sell-off in the equity market, bonds yields edged up and the dollar continued to tumble from Friday's levels.

The reason for the falls was obvious and had nothing to do with any developments here. The fresh concerns about the eurozone sparked by a spike in Spanish bond yields to near-record levels despite the €100 billion funding for a bailout of Spain's banks saw the usual rush towards the safe haven of the US dollar and US treasuries.

The renewed concerns about Spain and the potential that Europe might be called on to participate in a far, far larger bailout of the country's finances flows from Spanish government projections on Friday of a contracting economy and requests to the government from some of its regions for help in refinancing their debts.

Whether the issue is Spain, or Greece, or Italy or Portugal the pattern remains the same. The level of concern/fear in global financial markets rises and funds are yanked from this market, and others, and flow to the perceived safe haven of the US. The instant the fears subside, the money flows back.

It's been dubbed the "RORO" phenomenon, or the "risk on, risk off" response by institutions since the crisis.

The responses of central banks in the US and Europe to the crisis has been to flood their economies with near-costless liquidity. When risks are elevated investors are happy to accept negative real returns by holding those funds in the US or Germany or the handful of perceived safe havens. When they recede, those funds are deployed back into higher-returning assets and Australia's real interest rates are compelling by comparison with what's on offer elsewhere.

What's particularly interesting about the recent behaviour of the dollar is that we've tended to see the appeal of the Australian dollar to "risk on" investors as being a proxy for a commodity play and an indirect exposure to the China growth story.

It is difficult, however, to reconcile the strength of the rebound in the value of the Australian dollar relative to the US dollar over the past seven weeks (it momentarily went below US96 cents at the very start of June) with the continued tapering off of China's growth rate and the substantial falls in commodity prices this year. Most of our key commodities have fallen around 30 per cent.

That would tend to suggest that it is the liquidity in the currency and the real returns available from Australian fixed interest rate securities that is the biggest factor in the Australian dollar's fluctuations rather than the economic settings or, until relatively recently, the halo effect of the commodities boom.

HSBC produced some interesting research earlier this month that, while there has been a high correlation between commodity prices and the currencies of the countries generally regarded as having "commodity currencies" – Australia, Canada and Norway are good examples – two other countries also have a high correlation, but big trade deficits in commodities: Sweden and Poland. But they definitely don't have commodity-driven currencies.

HSBC concluded that the high correlation of commodity currencies to commodity prices – and the currencies of Sweden and Poland – to perceptions of risk has more to do with the RORO phenomenon than commodity prices.

That tends to be underscored by the way the Australian dollar has held up despite China's slowing growth rate and the steep falls in iron ore and coal prices, only to take an immediate hit because of the latest bouts of concern in Europe.

The state of the globe's financial flows is even more peculiar when one considers that every time the markets shift to "risk off" mode the funds pour back into the US, despite the continuing weakness of the US economy and the looming ‘'fiscal cliff' at the end of this year that could wipe more than 200 basis points of US GDP if the legislated tax increases and spending cuts aren't withdrawn and a less crude approach to tackling the chronic debt and deficit challenges in the US economy agreed.

With the US authorities, like their European counterparts, having apparently exhausted their policy options for responding to the anaemic state of their economy it doesn't look like anyone's notion of an attractive haven, particularly as there is a significant risk that the Federal Reserve board may devalue US dollar savings further by printing more money.

For the moment, however, when perceived risks are rising the depth of liquidity in the US dollar and in US treasuries overwhelms all other considerations, including the economic fundamentals.

The moment perceived risks are receding, funds will again pour into supposedly riskier economies that also happen to have stronger economic bases and medium term prospects than the US. It's a weird world.