AUD/USD Could Keep Pushing Higher As Fundamentals Support The Australian Dollar

The AUD/USD currency pair, which expresses the value of the Australian dollar in terms of the U.S. dollar, has performed very well in recent times, more recently rallying safely above the 2020 opening price of approximately 0.7016 (shown below). This reversal is stark, considering the significant drop we saw earlier in the year, as the COVID-19 pandemic really took hold.

(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)

Just as equity valuations can move with great volatility in the short term, currency prices can be volatile, but as with equities this does not imply that the underlying fundamentals are changing just as quickly. Rather, volatility in markets is driven by confusion as to fair value; it is a sign of frantic and chaotic price discovery. Only over longer periods of time can we see where fair value is being shaped by the market.

This is what has made 2020 interesting; sharp falls in risk assets and pro-risk currency pairs (including AUD/USD) followed by sharp reversals to the upside. The emergence of the COVID-19 pandemic began to truly affect markets from late February 2020 (when equities began to fall, albeit from levels that were probably over-bought regardless of the pandemic). Through the end of February and through March, risk-on currencies like AUD (often referred to as a commodity currency due to its commodity-export exposures) followed suit.

AUD weakened alongside equities, yet as markets readjusted, the Australian dollar bounced back. Further, its recovery has not really stopped. The collapse in oil prices, which I have discussed before, actually made the Australian dollar more attractive on the basis of terms of trade (the ratio between a country’s export and import prices) because Australia is a net-importer of crude oil. Comparing this to the United States’ terms of trade (as shown below) reveals that this year has in fact been favorable for AUD on a fundamental basis.

Australia vs. United States: Terms of Trade(Source: Trading Economics.)

Australia’s terms of trade may be softening overall, but the United States’ has fared materially worse. The widening gap is in favor of upside in AUD/USD. We can couple this with the fact that the U.S. Federal Reserve’s (pre-COVID) short-term rate was as high as 1.50-1.75% (target range), while Australia’s comparable rate was set at +0.75% at the start of the year. The Reserve Bank of Australia (RBA, the country’s central bank) has since dropped its rate to 0.25%, but so has the U.S. Fed (to 0.00-0.25%, in fact).

Therefore, AUD not only has a more favorable terms of trade profile this year, but also a far more favorable interest rate spread with USD. We can also draw attention to the fact that USD is weakening even against EUR this year, as the Fed’s heavy market interventions have generated ample USD liquidity to prevent traps and flights to safety (the USD is conventionally viewed as a safe-haven currency due to its world reserve currency status). With AUD also being a conventional “risk-on” currency, improved risk sentiment (which we have seen) should naturally favor currencies like AUD over USD, too.

In other words, what at once appeared to be a ‘perfect storm’ for AUD declines has in fact turned out to be a recipe for calm waters, clear skies and plain sailing. The current direction for AUD, to the upside, should continue, as interest rates are unlikely to be hiked in the near future. The United States is more likely to hike rates before Australia, since the RBA will be loath to create a positive interest rate spread for AUD/USD which could trigger even more AUD strength (which would weaken Australian export competitiveness). No, interest rates are likely to remain steady; the Fed has already indicated it is unlikely to hike rates before the end of 2022.

It is also unlikely that Australia will adopt negative rates; Governor of the RBA Philip Lowe referred to such a move as “extraordinarily unlikely.” Perhaps it would only consider such a move if the U.S. Fed entered into negative-rate territory first. Therefore, if we assume that rates remain largely (or completely) steady for the time being, and we assume oil prices remain mostly lower for longer, and yet we also assume that risk sentiment remains fairly steady, the current regime would appear to be positive for AUD/USD.

As I noted earlier, EUR has also been making headway versus USD. Therefore, it might help to take a look at the EUR/AUD chart to determine whether AUD strength is even broader.

EUR/AUD Chart in 2020EUR/AUD has fallen significantly off of its highs this year, but the pair has not been able to find its 2020 opening price of just under 1.60 (although it came close in early June). At the moment, we could say that AUD is simply “holding its own” against the euro. The European Central Bank has not raised rates this year (holding its deposit facility rate steady at negative -0.50%), and given that major European nations such as Germany have in fact benefited even more than Australia on a terms of trade basis, all-in-all we would probably expect EUR/AUD to be pushing a little higher on a fundamental basis.

Therefore, AUD is in fact holding EUR back from a sharper rise could be viewed as positive for the Australian dollar. Indeed, AUD is also gaining versus its Antipodean counterpart NZD (the New Zealand dollar).

AUD/NZD Break-out in 2020

While these higher prices may tempt one to short the currency considering the global risks and uncertainties that still remain, it is those risks and uncertainties that ultimately enabled AUD to strengthen. If risk sentiment remains positive, AUD could continue to rise over a longer time frame, while a collapse in risk sentiment (if material) would likely also affect oil markets in an important way, and could send U.S. rates into negative territory (before AUD rates), which would also be positive for AUD (at least to begin with).

At present, I believe AUD/USD will continue with a bullish directional bias.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Be the first to comment

Leave a Reply

Your email address will not be published.