The Australian Dollar has been range bound and trading inside the fair value bands, but where to from here?

In this article, we look at where the Australian Dollar (AUD) is relative to fair value, the implications of trend measures, and the impact of interest rate differentials on potential moves for the AUD against the US Dollar (USD). We also review how the AUD has performed on a seasonal basis.

Fair Value
The SSgA fair value chart for the AUD/USD shows the currency has moved from extremely cheap, being below our lower band of fair value, in 2001 to almost above the upper band of fair value in February 2004. (It broke through the band mid-month.) Currently, the AUD is in our fair value range and, at the 0.7500 level, is getting closer to the upper band but would not be considered cheap or expensive. The fair value bands are determined by a modified purchasing power parity model and are designed to incorporate approximately 85% of observations within the bands.

Trend Measures
One of the common measures used for determining whether a currency is in an up or down trend is to compare where it is trading relative to the 200-day moving average. The chart below shows the AUD over the last six years and its 200-day moving average. We see that the AUD was in a clear uptrend being above its 200-day moving average up until May 2004. This trend was in place since August 2002. Over the last few months, the AUD has moved around the moving average trying to keep the upward trend intact and is currently above the moving average level of 0.7117. The move above the 0.7350 level looks to be a break out from the range trading environment and the start of a new up trend.

The economic environment in Australia can be described as benign. Recent economic data releases have not surprised the market to a large extent. The fortunes of the US economy will be a bigger driver of the exchange rate. The quick result for the US election has removed the political uncertainty and focused the markets back on the economy. Any negative reaction to US data will help support the AUD up trend.

Interest Rates
The interest rate policy of a country should usually reflect the phase of the economic cycle. If we look at Australian interest rates out for two years, we see they are still rising but at a fairly shallow rate. When we compare this to US interest rates we see they are increasing at a more rapid pace. We can assume that the market expects the US Federal Reserve to continue to unwind the emergency easing and to continue tightening after that.

The futures market indicates that the 3-month yields implied in the future have the yield differential contracting from around 3.0% to 2.2%. This is still enough yield pick-up to justify hedging, but it usually means that the AUD will weaken.

Seasonal Factors
The AUD returns on a monthly basis in the chart below show that on average the AUD tends to rally in the last quarter and in January. September is usually a negative month. There is some justification for a rally in December and January as imports are usually down for these months. The chart shows a strong performance of the AUD in November and December for the last five years, ten years and the period since 1990.

Conclusion
Where does this leave positioning in the AUD?

For passive strategies, the interest rate differentials make it still attractive to hedge. Investors are being paid 3.25% currently and this is expected to continue to be above 2.5% for the next year to hedge their USD exposure back into AUD.

For strategic or active hedging, the trend measures seem to indicate a new uptrend has emerged. The resilience of the Australian economy seems to have been more convincing than the stop start nature of the US economic recovery. These types of turning points in trends have lasted for six to twelve months in the past. The break out from the recent range of the AUD makes it easier to be comfortable with the emergence of a new trend and to consider setting long-term positions to profit from it.

The forward interest rate differentials are starting to favour the USD as the market believes the tightening cycle in the US will continue over the next year. The Australian interest rate cycle appears to have at least one more rate increase built in and then the tightening cycle looks to be complete. This should favour being overweight the USD and underweight the AUD, but this likely will only be a compelling trade when the Australian yield curve is flat and the expectation of future interest rate increases have disappeared.

The seasonal nature of AUD returns could support a rally into the end of 2004. The setting of a firm base for the currency in October puts the AUD in a position to rally.

This material is for your private information. The views expressed in this commentary are the views of Lawrence Dryden through the period ended November 10, 2004 and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: November 16, 2004