What are the main drivers of the Australian Dollar Exchange?
When trading the Forex market, you need to be aware of the major drivers of an exchange rate, so then you’re able to get a better understanding of what makes a currency rise or fall against another in order to make more informed trading decisions.
We will focus on the Australian Dollar (AUD) in this article.
Australia and the country’s economic landscape
Australia’s economy is largely driven by the export of commodities. With a population of just over 26 million, it has the 14th largest gross domestic profit (GDP) in the world, and its dollar (AUD) is one of the top most traded currencies according to the BIS.
With a heavy reliance on the trade of agriculture, energy, and precious metals, such as nickel, gold, oil, iron ore, uranium, coal, and diamonds, Australia’s currency is part of what’s called a ’commodity currency.’ It is counter-cyclical and volatile, as is the correlating price of the commodities the country exports.
According to the most recent data from the Australian Bureau of Statistics (ABS), the country’s largest export markets are:
- China with 32% of all exports,
- Japan: 16%,
- South Korea: 7%,
- the US: 5%,
- India: 4%, and
- New Zealand, Singapore, and Taiwan: 3%.
Domestic manufacturing exports are only a small portion of the country’s GDP, and as such, Australia has to import a great deal of its machinery and parts, vehicles, pharmaceuticals, and electronics products, to name a few.
Data from ABS states that Australia’s main import partners are:
- China with 23% of total imports,
- the US: 11%,
- Japan: 7%,
- South Korea, Thailand, and Germany: 5%, and
- Malaysia: 4%.
Australia has experienced a long history of account deficits due in part to this lack of domestic manufacturing. In the last two years, however, the country has seen its largest trade surpluses on record, primarily as a result of the end of the mining boom and the shift from investment to production.
The country’s central bank, the Reserve Bank of Australia (RBA), has a reputation for being fairly conservative, only infrequently intervening in the currency market. Australia generally maintains one of the highest rates of inflation in the western world as a result of government policy and the RBA’s efforts to keep inflation under control.
Top drivers of the Australian Dollar exchange
Supply and demand is the greatest determining factor for driving the exchange rates of floating currencies, such as Australia’s dollar (AUD). So, what influences the supply and demand of the AUD?
There are a number of factors that have an effect: some long-term – like interest rate differentials, terms of trade, commodity prices, and inflation – and some short-term, such as investor sentiment and speculation.
Let’s dive right in.
Monetary policy and interest rate differentials
One of the main longer-term drivers of the exchange rate is Australia’s monetary policy and interest rate differential. The latter is the measure of the difference between the interest rates in Australia to those in other economies, such as the US, Japan, and Europe.
As Australia’s interest rates are generally higher than other major economies, they can increase demand for the local currency and therefore increase its value.
Interest rates are dramatically influenced by the monetary policy decisions of the Reserve bank of Australia (RBA), and as such, it is important to be aware of these decisions and what impact they will have. If you trade the AUD, policy guidance is issued on the first Tuesday of each month.
Inflation and Purchasing Power Parity (PPP)
Another important influencer of the exchange rate is inflation and the theory of purchasing power parity (PPP), as it has a major impact on the RBA monetary policy.
The idea of the PPP states that exchange rates between currencies are in equilibrium when their purchasing power is the same in both countries. This suggests that over a period of time exchange rates will correct themselves so that the cost of an identical basket of products or services is the same in any two countries.
When products and services are expensive in Australia relative to the same products and services in other countries, this may cause their demand to wane, the demand for AUD should also decrease and as a result, the currency will further lose value. Once the AUD has a lower value, it would then follow that the relative price of Australian goods for international buyers is lower, and less foreign currency is required to purchase these goods and services.
As we’ve covered earlier, the Australian dollar has a reputation for being a ’commodity currency’, meaning the AUD generally has a positive correlation with the price of its most promising exports, such as agricultural products, iron ore, and natural gas.
When commodities are in demand and prices are rising, you can expect the Australian dollar to be in a strong position. This is due to the fact that Australia’s trade partners must buy AUD and sell their own currencies in order to transact.
International trade is a very important factor in the rise and fall of the AUD. To transact in overseas markets, an Australian individual selling goods or services is paid with Australian dollars that the international buyer has had to first purchase. Any increase in exports will result in an increase in demand for the Australian dollar and it should then appreciate in value.
The opposite is observed when Australians demand more in imports. The Australian importer has to sell AUD for the relevant foreign currency to pay the international seller. This follows with an increased supply of Australian dollars in the foreign exchange market and its value should then depreciate.
Market psychology, also known as ’market sentiment’, is sometimes difficult to quantify. Still, it has a significant impact on currency pairs and other financial assets, especially over the short term.
When it comes to Australia, market sentiment impact on the Australian dollar is often linked to its association with the country’s commodity exports.
When commodity exports are high, there is a global sense of positivity and the AUD will generally increase in value. However, when trade partners purchase less in Australia’s oil or agricultural products, for example, the dollar can become weaker, as economic growth prospects are lower.
How can you trade the Australian Dollar?
Trading the foreign exchange market can be fairly complex – it is very large, highly liquid, and fast-paced. But this market is also a very popular option among retail traders! By performing fundamental or technical analysis prior to any investment, you may increase your odds of making sound decisions when deciding to trade the AUD.
Fundamental analysis refers to a study of the deeper workings or ’intrinsic value’ of companies or countries. From management personnel, industry conditions, assets, liabilities, among other criterias for companies, and economic growths, credit ratings, trade level, commodity prices, inflation, and more for countries – fundamental analysis attempts to assess the real value of an asset to determine if it is undervalued or overvalued.
Technical analysis, on the other hand, refers to the use of historical data, trends, and statistical data to determine the future direction of an asset. Price movement and volume from the past trading activity are studied to assess the potential investment’s future value and direction without taking into account fundamental analysis.
As with any investment strategy, it’s important to consider your own risk profile and have a good understanding of the cause and effect of market fluctuations. Also, remember to always follow your trading plan!
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