This bout of volatility is both good and bad for AUD

The Reserve Bank of Australia (RBA) has been very vocal about the need for a lower exchange rate to support trade exposed sectors of the economy. The bank was constantly stating that the level of the aussie was unjustified and it was due for a significant correction lower. This argument was founded on the idea that Australia was, and still is according to the RBA, fundamentally overvalued.

Glen Stevens and his colleagues on the board argued that the recent weakness in key commodity prices was paving the way for a significant drop in the aussie. Historically, the Australian dollar has been closely linked to particular commodity prices, namely those that make up the bulk of Australia’s export market; hence it is referred to as a commodity currency. At face value, this makes the AUD very vulnerable to falling commodity prices, particularly if it is the result on waning demand from Australia’s largest export partner, China.

Nonetheless, the dollar held up late last year and earlier this year despite concerns about China’s economy and a significant fall in key commodity prices. There are numerous reasons why this was the case, including massive amounts of monetary easing in other parts of the world which increased the aussie’s attractiveness. While the RBA was lowering interest rates last year, it wasn’t close to the scope of monetary easing in other parts of Asia, Europe and North America. And, the RBA was quick set expectations that it was gearing up for a period of stability in interest rates. In other words, it was very unlikely that the bank would cut interest rates further in the absence of any major shocks to the economy.

Even when the AUDUSD finally plummeted at the beginning of last month, this was more due to USD strength than AUD weakness. Now, recent softness in US economic data has sent bond, equity and FX markets into a panic. The market is now pushing back its expectations on when the Fed will being to raise interest rates.

It is even possible that the RBA amy raise rates sooner than the Fed, although the likely AUD strength that would result from this would make the RBA very uncomfortable. In fact, the main reason why we don’t think the RBA will hike rates sooner than the Fed is the effect that this would likely have on the Australian dollar. Apart from the purely psychological underpinnings of being first to raise rates, the move would send yield seekers flocking to AUD.

However, even if the RBA doesn’t raise interest rates before the Fed, the potential end of the USD strength story that has been dominating the FX market for over a month now may be over. The end result may be some consolidation trading in the medium-term which could see the aussie remain around current levels or even make a run at 0.9000.

In saying that, a break of support around 0.8650 may entice some more bears to the pair, especially considering that extreme volatility in FX markets is historically bad for carry currencies like the Australia dollar. Turmoil in FX markets decreases the appeal of carry trades as it makes returns far less certain, it can also weigh on commodity currencies which are generally considered to be risky currencies. Overall, the volatility may be broadly bad for AUD, but it may good for AUDUSD if the market continues to push out its expectations for higher interest rates in the US.