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G’day, forex mates! As you may or may not know, the Aussie has been trending broadly higher since the end of December 2016, shrugging off any disappointing economic reports that were thrown in its way.

What’s up with that?

Well, here the 3 major factors that have helped in sustaining the Aussie’s broad-based upward push.

RBA's AUD Trade-Weighted Index
RBA’s AUD Trade-Weighted Index

1. Rise in commodity prices

As you all should know by now, the Aussie dollar is known as a “comdoll” or commodity dollar because of Australia’s dependence on commodity exports (iron ore in particular) for economic growth. As such, Aussie has a positive correlation with commodity prices.

And as you can see below, Bloomberg’s commodity index has been climbing ever higher since mid-November 2016.

Bloomberg's Commodity Index
Bloomberg’s Commodity Index

Commodity prices have been rising for various reasons since mid-November. But with regard to base metals, the most cited drivers are infrastructure spending in China and optimism (and intense speculation) over Trump’s fiscal stimulus plans, which includes investing heavily in infrastructure other than the Great Wall of Trump.

In fact, the recent rise in commodity prices has allowed Australia to print back-to-back trade surpluses in November and December, which will likely help the Australian economy to rebound from its poor performance in Q3, which is the first quarter-on-quarter contraction since Q1 2011. And as I noted in my latest Economic Snapshot, Australia’s seasonally-adjusted surplus of A$3,510 million in December is the largest trade surplus ever on record. And this trade surplus, in turn, was due to exports surging by 5.4% to a record high of $32,630 million.

2. The search for higher yield

Australia is one of the few countries that have an “AAA” rating with a “stable” outlook from Moody’s and Fitch. Standard & Poor’s has a different opinion, though, since it gave Australia an “AAA” rating but a “negative” outlook. Still, that’s not so bad, and it also means that Australia is a relatively safe country for investors and lenders. At the same time, the RBA’s official cash rate of 1.50% is still one of the highest among the developed economies.

What these all mean is that Australia offers relatively high yet safe yields, which makes it quite attractive for investors. And the search for higher yet relatively safe yields in a low-yield world has benefited the Aussie in two ways.

The first is that demand for the higher-yielding Aussie itself is being sustained by this search for higher yields. And the second is that Australian bonds have been in great demand recently. In fact, a Bloomberg report from earlier, um, reported that:

“Australia’s government sold A$11 billion ($8.5 billion) of 11-year debt notes in its biggest-ever bond transaction, as investors hungry for higher yields set aside concerns stubborn budget deficits will cost the nation its AAA credit rating.”

Admittedly, there is no breakdown yet on how many foreign investors bought. Moreover, the RBA prefers to see more capital inflows into business investments. Nevertheless, capital inflows towards Australia through bond purchases still benefit the Aussie.

3. Monetary policy stances

If you can still remember, both the Aussie and the Kiwi got burned in the run-up to the December FOMC statement, despite rallying commodities and the prevalence of risk appetite at the time.

The rationale for this is that market players were expecting capital to flow out from Australia and New Zealand towards the U.S., thanks to the expected narrowing in interest rate differentials, as well as expectations of faster growth in the U.S., courtesy of Trump’s fiscal stimulus plans.

And when the Fed did hikes and communicated the possibility of up to three rate hikes in 2017, both the Kiwi and the Aussie weakened for a couple more weeks. This time, because of expectations that interest rate differentials would narrow even more and at a faster pace than expected.

However, some of the Fed’s recent communications and recent uncertainty related to Trump have dampened rate hike expectations a bit. And to illustrate, the CME Group’s FedWatch Tool shows that by the end of the year, the market has only priced in the following:

  • a 95.2% probability of a single rate hike
  • a 74.7% probability of two rate hikes
  • a 41.4% probability of three rate hikes
CME Group's FedWatch Tool
CME Group’s FedWatch Tool

So, market players obviously don’t have a lot of faith that we’ll be getting three rate hikes from the Fed this year.

For the RBA’s part, it plans to keep the cash rate steady at 1.50% for a while. And the rationale for this, as revealed by the latest RBA meeting minutes is that (emphasis mine):

“In considering the stance of monetary policy, members viewed the near-term prospects for global growth as being more positive, although recognised the risks from policy uncertainty in the medium term. Stronger growth had contributed to higher inflationary pressures, including higher commodity prices, which had implications for the future stance of monetary policy in the advanced economies in coming years. Long-term bond yields had moved higher in many advanced economies.”

“Domestically, the economy was continuing its transition following the end of the mining investment boom. The fall in GDP in the September quarter had reflected some temporary factors. Looking forward, resource exports were expected to make a significant contribution to growth over the forecast period and the drag on growth from falling mining investment was expected to wane. The depreciation of the exchange rate since 2013 had also assisted the economy in its transition following the mining investment boom.”

In short, there is no need to cut rates further because the contraction in Q3 GDP growth is only temporary, and GDP growth is expected to rebound and continue to grow, thanks to commodities exports.

And while the RBA reiterated its usual statement that “An appreciating exchange rate would complicate this adjustment,” RBA Governor Lowe had this to say during the Q&A portion of his February 9 speech (emphasis mine):

It’s hard to say that the exchange rate is fundamentally too high. If the global outlook were to change and the exchange rate/interest rate combination led to growth being downgraded, then you could make the case that the exchange rate was too high. But at the moment I struggle to say the configuration is leading to growth outcomes that aren’t satisfactory.”

Final Thoughts

Too long, didn’t read? Well, you hurt my feelings. But to summarize, expectations that narrower interest rate differentials would cause capital outflows from Australia towards the U.S. has been reduced lately because the RBA plans to keep rates steady while the market only expects two rate hikes from the Fed by the end of the year.

And these, in turn, have allowed market players to shift their focus on the relatively high but safe yields that Australia and the Aussie dollar offer, as well as the upward march in commodity prices.