Aussie dollar trades at five month high

The Australian dollar (AUD or Aussie) rose to a five month high of 1.0756 versus the US dollar (USD) last Thursday and reached a new 15 year high versus the Canadian dollar. The AUD/USD rallied 9% since December and has retraced all of its losses from late October. The currency traded as low as 0.9300 in late October, pressured by fallout from the EU debt crisis as investors sought safe haven in the USD.

The Aussie is supported by the recent improvement in risk sentiment, yield differential, rising commodity prices and stronger economic data. The Australian overnight rate is 4.25% compared to the near zero in many of the industrialised nations (US, Japan, UK) and well above Canada’s overnight rate of 1%. The current improvement in risk appetite encourages carry trades: the borrowing in low yield currencies in search of higher yield. This is in part why the Aussie is gaining against the Canadian dollar. The Fed’s recent pledge to keep interest rates low through 2014 boosted risk appetite, equities, commodities and carry trades.

The Aussie also benefits from improving economic data and reports of widening of the country’s trade surplus in December. Australia’s December trade surplus widened to A$1.7 billion, well above estimates of A$1.2 billion surplus. The 2011 trade surplus rose to a record, boosted by stronger exports of commodities; in particular gold and coal. In addition, December manufacturing data from China, US and the EU strengthened in December. These reports suggest the global economy is strengthening and China’s economy will reach a soft landing. Australia has strong economic ties to China.

Another positive for the currency is that Australia’s credit rating is AAA.  This is attracting capital inflows because many European nations and the US have faced credit downgrades.

Focus turns to Tuesday’s Reserve Bank of Australia (RBA) monetary policy meeting. The central bank cut its benchmark interest rate by 25bps in December to 4.25%. This was the second rate cut in last two months due to concern over the “fragile global economy”. According to cash rate futures, 58% of traders expect another 25 basis point rate cut at the 7 February policy meeting. Moderation of Australia’s inflation rate, continued concern about the global economy and the strength of the Aussie may encourage the central bank cut rates. Australia’s fourth-quarter CPI was reported at 3.1%, down from 3.5% in the previous quarter. The RBA’s inflation target range is 2% to 3%.

An RBA rate cut may spark modest liquidation selling pressure for the Aussie and trigger technical selling as the market is nearing overbought on relative strength indicators. Future price direction will remain closely correlated to risk sentiment and the direction of commodity prices.