The top 5 factors that affect the value of the Australian Dollar

How is the value of the Australian dollar determined?

The Australian dollar (AUD) derives its value from the interplay of several macroeconomic factors. These factors conspire with one another to shift exchange rates, and ultimately determine an evolving value for the AUD over time. Of course, just like any other currency, the value of the currency isn’t just defined by issues contained just to the Australian economy. It is also determined by the relative strength or weakness of the currency for which an AUD is being exchanged. Because this strength and weakness can differ depending on the currency pair in question, trade weighted averages are often used to calculate an overall value for the AUD.

The top factors that affect the AUD

Below are the top 5 factors that affect the price of the AUD:

1. Interest rate differentials
2. Commodity prices
3. Purchasing power parity
4. Government credit ratings
5. Sentiment and speculation

Interest rate differentials

The biggest driver of changes in the AUD's value is the interest rate differential. The interest rate differential is the relative benefit an investor receives from investing in one country’s assets over the other. For example, if interest rates in Australia are 1.50%, but are higher in the US at 2.40%, then an investor can get a great return by buying US assets. This has the effect of pushing down the value of the AUD, as investors sell AUDs and buy US dollars in order to invest in US assets.

Commodity prices

Historically, the AUD has largely followed the price of Australia’s key commodity exports, and the nation’s overall terms of trade, earning the currency the label of being a 'commodity currency'. The reasoning behind this is that in order to buy Australian exports, Australia’s trading partners need to also buy AUDs, and sell their local currency, to execute the transaction. The dynamic can be witness most pertinently in the price of iron ore, which owing to the ebbs and flows in Chinese demand for the mineral, has underpinned the AUD's strength and weakness for several decades.

Purchasing power parity

The principle of purchasing power parity suggests that an exchange rate is at equilibrium when it reflects the difference in price between a basket of goods in two separate economies. Although an imperfect model for examining the 'fair' value of a currency, the model suggests that due to price arbitrage, a currency pair ought to err towards its purchasing power parity. For the AUD, and using the famous Big Mac Index as the benchmark, the AUD is overvalued against the US dollar, suggesting that the AUD/USD ought to depreciate over time as relative price difference erode.

Government credit ratings

The Australian government’s credit rating can have a marginal impact on the AUD. That’s because Australia’s credit rating impacts the risk profile of its debt, which directly influences the cost the government has to pay on the debt it owes. A bad credit rating makes buying a country’s debt riskier and less attractive, reducing the overall demand for its currency. Although not a problem in recent history, with the Australian government maintaining a AAA credit rating for over 15 years, events that have threatened this status has brought about short-term weakness in the AUD in the past.

Sentiment and speculation

The AUD is arguably the most popular growth and risk proxy in global financial markets. It is often used as a barometer, and trading device, to benefit from short-term changes in sentiment towards global economic growth, and market risk. Some of this is tied back to the fundamental fact that being a 'commodity currency', the Australian economy is highly exposed to changes to global economic activity. Hence, when there is a prevailing good mood in the market, the AUD will quite often climb, while if there is a prevailing pessimism, the AUD will often fall.

AUD/USD trading: key takeaways for traders

It’s often said that the AUD 'goes up the escalator, and down the elevator shaft'. What this means is that when the AUD rallies, it does so gradually, but when it falls, it falls suddenly. As a result, trading the AUD is considered a relatively 'risky' currency to trade, especially compared to its major G4 counterparts. Even still, the AUD is a highly liquid currency, meaning for those with the appropriate risk appetite, trading the AUD can provide a trader with ample opportunities to speculate on changes within global financial markets.

Australian dollar forecast: what comes next in 2019?

The AUD remains mired in a downtrend. The primary cause of this has come consequent to a historically rare negative interest rate differential between the US and Australian economies. This phenomenon is largely attributable to a deterioration in the global and domestic economic outlook, courtesy of economic weakness in China, and a sustained fall in Australian house prices. The trend is unfolding even despite a steady increase in iron ore prices, and a lift in the nation’s terms of trade. Considering these factors, the downward trend for the AUD looks unlikely to abate before the end of 2019.