Henry Yu and Annabel Yenson
The Australian dollar is currently standing higher than its pre-COVID evaluation in 2019, recovering roughly 17 cents to the US dollar. Australia did not escape the economic crisis that the coronavirus pandemic swept the world into in 2020, however, the Australian economy has more or less recovered with the return of a ‘COVID normal’ partnered with a vaccine rollout plan. Additionally, the recent rise in commodity prices and changes in interest rates and monetary policy has seen the Australian dollar strengthen against other countries’ currencies.
COVID-19 threw the global economy into chaos and saw Australia thrust into its first recession in 29 years, as the decline in GDP for two consecutive quarters was the product of both the bushfires and the uncertainty of the recent outbreak. Currently however, the proven efficacy and rollout plans of COVID vaccines, partnered with the lack of local transmission has seen some confidence restored in Australian markets.
AUD and Interest Rates
Despite there being a number of factors that influence the Aussie dollar’s value, the biggest single factor on the menu, in the long-term, is still the interest rate differential. As we can see on the graph, the Reserve Bank of Australia has been setting a cash rate target higher than the US since 2000.
So how does that have anything to do with our currency? Think about it, if interest rates in Australia are very high relative to other countries, that makes it attractive for investors to invest in Australian securities, such as Australian government bonds as they will be generating higher returns.
But first of all, in order to purchase Australian financial instruments, investors have to convert their local currencies into the Aussie dollar. This significantly increases the demand for the AUS and hence shifting the Australian dollar up.
This phenomenon was seen during the post-GFC era. Some of you would probably remember there was a time when AUD is more expensive than the US dollar. The most well-known reason for the surge of the Aussie dollar is our country did not suffer from a devastating economic downturn as most other developed nations did. However, by a closer examination of the interest rate and AUD price trend, we can see a direct positive relationship between a rise in interest rate and appreciation of AUD.
As much as the idea of putting money in a high-interest rate environment sounds tempting, investors are extremely cautious of exchange rate fluctuation.
As discussed before, foreign investors get to invest in our country only by using Australian dollars, which ultimately means they will be receiving their returns in our currency. Nevertheless, their local stores wouldn’t accept our plastic notes. They have to exchange back to their local currency to realise those profits. Therefore, the difference in the value of AUD is a significant factor that will influence global investors’ real returns.
Generally speaking, investors would be happy to enjoy the benefit of high-interest rate in Australia when the overall market condition is stable, as the risk associated with fluctuation in the exchange rate is relatively smaller. On the other hand, once the economic outlook is deteriorating and the market starts to become more volatile, investors’ risk tolerance tends to be lower, thus they will be selling off Australian assets to minimise their exposure.
To illustrate this, we can use the VIX – a metric representing the market’s expectations for volatility in the capital market over the coming 30 days. The recent spike in March-April 2020 was due to the well-known COVID-19 outbreak. During this period, the AUD/USD currency pair plummeted to 17 years low, the sell-off is primarily due to the shift in the market’s risk sentiment.
Due to this characteristic of the Aussie dollar, many investors also regard AUD as a high-risk currency, partly due to its high volatility, but also in direct contrast to, say, Japanese Yen, which is a ‘safe haven’ for investors.
Recently, the AUD again reached multi-years high of 80 cents USD per dollar . Given the vaccine rollout, steady economic recovery and increasing demand for iron ore, AUD is expected to remain strong over the course of 2021.
Australia’s Economy Remains Strong
While the rest of the world struggled to flatten the curve and reduce hospital intakes, Australia, alongside New Zealand, received global praise for their handling of the pandemic. By combatting the second wave and having consistent zero transmission days, businesses and Australians have been able to return to normal, lowering the risk of the economy grinding to a standstill once again. Additionally, the approval of the AstraZeneca and Pfizer vaccine provides further reassurance that Australia has significantly lowered the potential for a third wave. This has allowed people to return to ‘COVID normal’ which not only saw consumption increase, but also resulted in Australia exiting its recession in Q4, surpassing expectations and seeing the economy grow by 3.1%. As a result, the risk of investing and converting foreign currency to AUD has decreased significantly, and in comparison to Japan and US, who are still struggling with the high infection counts, has decreased the willingness to use the JPY and USD whilst increasing the attractiveness of the AUD.
AUD as a Commodity Currency
The economic recovery has been only one aspect of the rise in valuation of the Australian Dollar. The AUD is also a commodity currency, as its value heavily relies on its import/exports for its revenue. Iron ore mining is the sixth largest revenue earner, bringing in over $128.6 billion dollars in 2021. Iron ore is one of the main inputs in the manufacturing of steel, and Australia’s main exporter, China, has recently increased its steel production in an attempt to stimulate their economy.
This is arguably the main driver in the rise in the AUD, as there is a projected 13.5% rise in this year’s annual industry revenue despite potential setbacks from COVID-19. This rise in demand, followed by a lack of supply from around the world has seen the price of iron ore almost double, going from $90US/tonne to $170US/tonne in the span of a year.
This has also seen the AUD strengthen against the CNY to levels that surpass pre-COVID values, with the current price being $5.04 compared to $4.82 in December 2019. As more countries look to stimulate their economy, construction and infrastructure will increase, as well as the need for raw materials to do so. Despite China’s sanctions over a plethora of Australian exports, iron ore is not one of them. As one of the biggest steel producers, China requires 60% of its iron ore from Australia. Whilst they may be looking for alternative suppliers, Australia’s quality of iron is unchallenged, with 96% of its exports being high grade hematite, which has a higher iron content and requires less energy to create better quality steel. Regardless, the notion of China breaking away from its main source of high quality iron is not a feasible possibility over the next five years, however, it should be further analysed for the distant future. As for the present, Australia should enjoy the boost in revenue to the economy as the AUD rises against its Forex currencies.
To conclude, the Aussie dollar is a relatively volatile currency, and its value is positively related to the general economic condition. We would expect AUD to perform well throughout 2021 as global demand for base metals due to increasing government spending on infrastructures will likely keep commodity prices high. Finally, effective vaccine rollout is playing an essential role in stabilising the market outlook, in which we can expect further support to the Australian dollar.
Henry Yu is a Research Analyst in UNIT – UniMelb, specialising in forex and equity trading.
Annabel Yenson is a Research Analyst for UNIT – University of Melbourne, majoring in economics and finance
Geoscience Australia: https://www.ga.gov.au/scientific-topics/minerals/mineral-resources-and-advice/australian-resource-reviews/iron-ore#:~:text=Approximately%2096%25%20of%20Australia’s%20iron,grade%20hematite%20iron%20ore%20deposits.
Market Watch: https://www.marketwatch.com/investing/index/vix/charts
Trading Economics: https://tradingeconomics.com/australia/interest-rate
Edited by Victor Yan and Samuel Subramaniam
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.