Oct 2011 04

The Australian Dollar: What Every Forex Trader Needs To Know

Participating in the forex market requires focusing on only a few currencies. XE.com, one of the worlds most popular currency conversion sites, lists 165 currencies available. Of these, only a handful take up most of the daily trading volume, which extends into the equivalent of trillions of U.S. dollars. One popular foreign currency is the Australian dollar, which trades under the symbol AUD. Australia is a largely stable country with rich natural resources that serves as a major trading partner for many Asian countries. A history of stable government policy with high interest rates and a non-interventionist stance in the currency markets make this country well-known to investors.

Central Banking

The Reserve Bank of Australia (RBA ) is the central bank that manages the Australian dollar. Incorporated in 1960, it is wholly owned by the Australian national government. The RBA has three objectives: Maintain the stability of the currency, maintain full employment and facilitate economic prosperity. When the RBA was incorporated, it replaced the Commonwealth Bank of Australia, the countrys previous central bank, existing since 1911. The RBA is renowned for a hawkish approach to inflation, routinely keeping interest rates at high levels to combat it. This high-rate policy was not enough to prevent a housing bubble from forming. Additionally, the RBA is often challenged by the commodity cycle, since Australia is a commodity-rich country.

The Commodity Cycle

Gold, oil, diamonds, iron ore, agricultural products, coal, copper, natural gas and uranium are the major commodities available from Australia. (1) As such, the rise and fall of the prices for these goods plays a huge role in the strength or weakness of the Australian dollar relative to other currencies. Since commodities like oil and gold are priced in U.S. dollars, the commodity cycle virtually dictates certain currency pairs, such as the USD/AUD and its complimentary pair, the AUD/USD. Additionally, exchange rates with other currencies are indirectly impacted by the commodity cycle.

Higher commodity prices result in rising inflation, which results in the RBA raising interest rates. (2) This in turn makes the Australian dollar an attractive currency for investors looking to execute a carry trade. A carry trade involves selling a currency with low interest rates and buying a currency with high interest rates. This influences the exchange rates even more, which may result in moderating or increasing inflation, depending on the commodity cycle. The RBA thus has to track multiple factors when deciding whether or not to raise interest rates.

Economic Indicators to Watch

When using a commodity-influenced currency like the Australian dollar, investors need to pay attention to reports on crop planting, weather, harvests, metal prices and mine output. The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES ) releases regular reports on these subjects, which are freely available to the public. Gross Domestic Product (GDP ), industrial production, trade balances and inflation are also important reports to watch. Given the RBAs approach toward inflation, the inflation report may be the most important of them all, since it directly influences interest rate decisions.

Trading The Australian Dollar

When inflation is high, other currencies tend to be weak. The Australian dollar does well in inflationary times, making it a great contrarian trade for investors. Consistently high interest rates make this currency desirable for conservative traders seeking to earn profits from interest rate arbitrage. Australia has a stable economy with a few negative circumstances, such as the lack of a domestic manufacturing sector and a large current account deficit. Nevertheless, the country is strong enough for investors to include the Aussie in their trades the world over.

References

(1) https://www.cia.gov/library/publications/the-world-factbook/geos/as.html

www.news.com.au/money/interest-rates/inflation-rate-remains-above-rbas-target/story-e6frfmn0-1226102651975