Sullivan Draft 1

The Australian dollar ($AUD) was introduced in 1966, prior to that time the Australian pound was used. When introduced the $AUD was set at a pegged rate with the British pound of 0.8 GBP per $AUD. A party to the Bretton Woods agreement the $AUD was effectively pegged against the US dollar, but this was in fact more of a by-product of its peg to the British Pound. After the breakdown of the Bretton Woods agreement the $AUD went through a series of controlled and dirty floats until treasurer Paul Keating floated the $AUD in December of 1983. Since floating at 90 US cents per $AUD, the $AUD has been as low as 48.33 US cents per $AUD 3rd April 2001, and as high as 97.86 US cents per $AUD on the 16th July 2008. [1] The purpose of this paper is to identify what drives the $AUD and why it fluctuates so wildly.
Current financial wisdom tells us that we can use interest rate parity, purchasing power parity and/or differentiation in consumer price indexes to hedge for currency.
True that the very mechanics of calculating a forward contract will provide protection for movement in exchange rates between two currencies due to the interest rate differential and stop any effective arbitrage opportunities but in reality that is about all that it done.
Over any time period from December 1983 until the present there is no correlation between the $AUD and USD exchange rate. What does drive the $AUD/USD exchange rate and is it predictable?

Using the process of interest rate parity, that same calculation that banks use for forward rates, the $AUD should now be trading somewhere south of 40 US cents per $AUD. At the end of February 2009 the $AUD was trading at 64.54 US cents per $AUD. Perhaps that other stalwart of currency valuation Purchasing Power parity will provide a better guide. Using the calculation of differential in Consumer price indexes the $AUD should be trading around 73.36 US cents per $AUD.

The Early Days 1983-1990
Data would suggest that from the initial float through to the late 1980’s early 1990’s the $AUD was correlated to base metals. Australia is the largest world exporter of base metal ores and concentrates [2]. In the early days of the floating currency this was shown to be true as the exchange rate traded in line with the base metals prices. As base metal prices rose so to the demand for $AUD and the exchange rates rose with the increased demand.
For the period 1983 to 1990 there was strong positive correlation between the base metals index and the $AUD (.60). Conversely there was a negative correlation during this time between the $AUD and both interest rate differentiation and consumer price index differentiation.
During this time there was high inflation and high interest rates in both the US and Australian economies, and while there should have been considerable depreciation of the $AUD there was

Settled 1990-2005
During the nineties and into the naughty’s the $AUD USD correlated to the gold price. Again neither interest rates nor consumer price indexes showed any correlation.
Australian inflation brought under control and better than the US economy.

Now 2005-
The current economic scare and recession has caused the $AUD to fall off the planet, trading at mid 90’s during June and July of 2008 the $AUD plummeted to the mid to low 60’s by November 2008. Investors have left the $AUD in droves to the perceived safe harbor of USD. Base metal prices have dramatically fallen while precious metals including gold have continued to strengthen. The $AUD has continued to show correlation with the base metals index.

The Future
To truly predict the $AUD one need to follow the correlation of the $AUD to the base metals prices. Base metals are traded on many future exchanges, by looking at the futures for the base metals prices we should be able to predict

1. Reserve Bank of Australia

2. Nation Master World Economics

3. Import Export

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