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Why the Aussie dollar is flying high

By Stephen Koukoulas

The Australian dollar has been rising strongly over the past six months and not just against the US dollar where this morning it is hovering just under 78 cents.

The Aussie dollar is also buying over 0.72 euros, the highest level it has been since early 2015 and is up some 10 per cent since May last year. It is also strong against the British pound, Japanese yen and Canadian dollar. In simple terms, the Aussie dollar is flying.

The reasons for the strength are clear.

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Importantly, Australia has some of the highest interest rates in the industrialised world which means global investors are keen to pick up a positive yield with their Australian holdings versus those in other countries. With the RBA signaling that is has no plans to cut interest rates and rates in Europe, Japan and Canada unlikely to be hiked any time soon, the Australian dollar is likely to remain attractive for some time.

The other vital element supporting the Australian dollar has been the surge in commodity prices over the past year or so and the fact that this is showing up in a spectacular turnaround in the international trade balance from sizable deficits to what was a record monthly trade surplus in December.

With Australia’s exports dominated by bulk commodities, when the price of these commodities increases, the companies that extract the iron ore, coal and other materials enjoy what is a windfall gain in their earnings. A number of things accompany this. As foreign currency export receipts rise, these firms need to convert a large proportion of these proceeds into Australian dollars – this simply increases demand and pushes the dollar higher.

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It also means that there is an income boost for the overall economy. This improves general conditions, sees a surge in tax revenue to the government and the budget position is improved. At a time when the triple-A credit rating is hanging by a thread and as a result there was concern that a credit downgrade would undermine the Australian dollar, this fortuitous but clearly good news on the budget materially reduces the chances of a credit downgrade, which improves confidence in Australia and with that the currency moves higher.

Forecasting moves in the Aussie dollar is a tough gig. That said, there are reasons to think that it is now fully valued – in other words, it is due for something of a fall.

The market is under-estimating the risks of an RBA rate cut given the low inflation climate, relatively high unemployment and record low wages. If at any stage, the market comes to price in a possible further rate cut, the dollar would come under pressure,

If, as appears likely, the commodity price rally runs out of steam (coal prices have already dropped for their recent highs) , then other key support for the Aussie dollar reverses.

It seems a track back below 75 US cents could quickly emerge, with similar or larger falls against the euro, British pound and Canadian dollar.