Sullivan Final

Australian Dollar US Dollar
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 freely 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.
AUD-USD.bmp
Logic
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 is done.
Using the process of interest rate parity, that same calculation that banks use for forward rates, the $AUD should now be trading 39.34 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. Finally a review of parity calculation using the real interest rate, that is nominal interest rate less underlying inflation as measured by consumer price index. Real interest rate parity would provide a current exchange rate of 48.24 US cents per $AUD.
At any time period from December 1983 to now there is no correlation between the interest Rates, inflation or indeed a combination of interest rates and inflation, to the $AUD exchange rate with the USD. During this time frame there has generally been higher interest rates and inflation in Australia than in the United States, this would lead to a general depreciation of the $AUD against the $US. As recent as October 2007, as reported by Bloomberg, TD Securities analysts were projecting parity between the $AUD and $USD, that is $AUD = $USD.[4]
Projections.JPG
So, what does drive the $AUD/USD exchange rate and is it predictable?

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 fairly erratic movement in the currency from highs above 90 in 1984 to lows around 60 in 1986. The $AUD finished the decade at around 77 to 78 US cents per $AUD. Base metals also experienced these wild fluctuations.

Settled 1990-2005
During the nineties and into the naughty’s the $AUD USD exchange rate settled into the current trading pattern, strong correlation to the gold price and correlation to base metals.
Australian inflation was brought under control and better than the US economy, in general this was a period of strong and consistent growth for the Australian economy as reported by the World Bank [6]. The $AUD maintained its correlation to the base metals index and in the later half of the time frame copper in particular.
Interest rates showed some correlation for short period during this period but as soon as base metals started to rise in price so to did the $AUD and any association with interest rates disappeared. Consumer price indexes showed no correlation.
While I refer to this time frame as settled the $AUD still traded from highs above 80cent to lows below 50cents, in general the rises and falls were less severe in timing and the $AUD had a fairly consistent downward trend through 2001, as base metals settled and started to rise so to followed the $AUD.

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.
In October 2007 Forbes reported the $AUD had its biggest single day loss, just over 3 US cents, since it was floated 1983. The cause cited by Forbes was the risk averse movement to the safety of the $US caused by the rise in concern from sub-prime mortgages. A full year later the $AUD dropped like a rock opening October 2008 at 79.62 US cents before falling to 61.22 US cents by the 28th October. A full 23% depreciation in just 19 trading days, similarly the base metals index fell by 24% in the same time frame.

The Futures Market
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 movement in the $AUD.
After obtaining ten years of futures contract data for copper and comparing that data to the spot price of copper there appears a high correlation between the spot copper price and the copper futures contracts sold. The same data also shows strong correlation to the $AUD/USD. On the surface we could use the futures price to estimate movement in the $AUD/USD, unfortunately a review of the graph below shows that the spot price is more an indicator of the three month future than the reverse leaving us with no real prediction indicator of movement in the $AUD/USD [11][12].
Copper.JPG
Arbitrage and money making opportunityitalic text
Forward rates are provided by the exchange markets through many banks, all of Australia’s four large banks offer forward contracts. These forward contracts are based on interest rate parity, and although the banks have access to a variety or rates there does not appear to be an effective opportunity for arbitrage.

In Summary
Although the worlds sixth largest traded currency the $AUD is driven strictly by demand for the commodities that underlie the Australian economy. As mineral prices rise to meet the growth markets of China and India and the seemingly endless Japanese demand for coal continues the $AUD will continue to remain high against its US counterpart. The $AUD is not considered a safe harbor for the risk averse even though the Australian economy is ranked highly amongst OECD nations and has had over 10 years of positive GDP growth according to the World bank.[6]
To truly predict the movement in the $AUD we need to understand what drives demand for base metals. The copper market, as with all base metals, is based on simple supply and demand metrics, supply of copper comes from the mining smelting process as well as recycling. The demand side of the equation is produced by the consumers of copper, including but not exclusively the developing nations that are building vast infrastructure. China’s seemingly insatiable growth, the development of major cites and the drive to electric cars are reported by Reuters and Marketwatch as key drivers of the current copper market [7][8]. While current demand is still historically strong the demand is fickle, with many seemingly unrelated issues affecting the price, Purchasing reports that ‘swine flu’ is causing the copper price to fall [9]. Commodity online is speculating that China is stockpiling copper and other base metals at low prices to smooth market fluctuation and cover expected rises in base metal prices that are expected to occur if and when there is a US housing and construction recovery [10].

1. http://www.rba.gov.au/ Reserve Bank of Australia

2. http://www.nationmaster.com/graph/eco_wor_tra_exp_bas_met_ore_con_nes-base-metal-ore-conc-nes Nation Master World Economics

3. http://import-export.suite101.com/article.cfm/top_gold_countries Import Export

4. http://www.bloomberg.com/apps/news?pid=20601087&sid=aT40HrMyjmu0&refer=home Bloomberg

5. http://www.forbes.com/feeds/afx/2007/08/17/afx4029571.html Forbes

6. http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/ Worldbank

7. http://uk.reuters.com/article/allBreakingNews/idUKN0225693520090402 Reuters

8. http://www.marketwatch.com/news/story/chinas-giving-copper-some-fuel/story.aspx?guid=%7B5856B016-4A3B-43B4-9AEA-C153AC6D6174%7D Marketwatch

9. http://www.purchasing.com/article/CA6655240.html Purchasing

10. http://www.commodityonline.com/news/Base-Metals-Why-is-China-stockpiling-Copper-16662-3-1.html Commodity online

11. http://www.nymex.com/HG_spec.aspx NYMEX Copper Futures

12. http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/ World Bank

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