Introduction
The Australian dollar is showing unexpected resilience despite challenges in market sentiment due to U.S. tariffs, leading to speculation about its diminishing role as a risk proxy.
Context
The Antipodean currency just recorded its steadiest quarter in two years, rising nearly 2% this year to around 63 cents, even as U.S. shares have fallen more than 4%.
- This breakdown in correlation is impacting trade volumes in the Aussie.
- Challenges for Australian investors in the U.S..
- Disruption in financial markets caused by U.S. President Donald Trump.
Developments
An unusual shift in the U.S. dollar, which has declined alongside stocks for only the third time in 25 years, is influencing this trend, according to Bank of America currency strategist Oliver Levingston.
Nick Twidale, chief analyst at ATFX, noted that the Aussie is not behaving as expected, leading to a decrease in trading volumes. He suggested that it appears the Aussie has lost its correlation with traditional risk metrics.
The Aussie gained its reputation as a risk proxy because of Australia's export profile, selling commodities like iron ore, coal, and gas that are essential to global economic growth.
- Over four decades of being freely convertible.
- Expectations that these exports justify the currency's tracking of global economic sentiment have been self-reinforcing.
However, analysts at Westpac state that its relationship with U.S. stocks is currently weaker than it has been since the onset of the pandemic, accelerating a decline in the Aussie's correlation with global risk that has unfolded over the past decade.
Richard Franulovich, Westpac’s head of foreign exchange, indicated that Trump's presidency has fundamentally altered the relationship between currencies and equity risk metrics.
Analysts also note significant changes in the last ten years, including the growth of Australia’s offshore investment portfolio and a reduced reliance on commodities, contributing to a surge in Australia’s net international assets.
Lachlan Dynan, a foreign exchange strategist at Deutsche Bank in Sydney, mentioned that Australia is now less dependent on global growth from a balance of payments perspective than it once was.
The Aussie has traditionally served as a means to speculate on the global economy, particularly with regard to China, its largest export market. However, its usefulness may diminish as it becomes less reliable as a risk indicator, prompting traders to seek alternatives or adjust their expectations regarding the currency's sensitivity to risk.
Data from CLS indicates a potential shift, as AUD/USD trading volume has remained flat for four years while nearly every other major currency pair has seen growth.
Mark Elworthy, head of fixed income, currencies, and commodities trading at Bank of America in Australia, reported that clients show interest in cross-market trades, preferring investment in Australia over riskier positions in China.
Westpac’s research reveals that the correlation between U.S. stocks and the Australian dollar has dropped from above 0.6 in 2022 to below 0.4 now.
Since around 2013, the Aussie's relationship with global risk across various markets has been gradually declining, coinciding with a significant expansion of Australia’s offshore assets.
Australia's net foreign equity position reached a record A$656 billion at the end of last year, significantly increasing from nearly zero a decade ago.
The behavior of such a large position during a major crisis remains untested, but it is possible that capital flows back to Australia could create upward pressure on the currency.
Additionally, Huw McKay, a former chief economist at BHP and current visiting fellow at the Australian National University in Canberra, highlighted that commodity exporters' currencies are also becoming less linked to commodity markets.
Using a model that measured the Australian dollar against the country’s terms of trade from 1996 to 2019, McKay noted a strong correlation with a drop below 0.6 between 2016 and 2023.
He remains uncertain if this represents a permanent shift or a temporary anomaly, but traders are not waiting for clarity.
Traders in dealing rooms have observed that previous patterns of trading based on tariff announcements are no longer consistent.
Conclusion
Overall, the changing dynamics of the Aussie amid evolving global economic conditions highlight a need for stakeholders to recalibrate their strategies and expectations regarding this currency's role as a risk proxy in the financial markets.