Great Graphic: Australian Dollar and Iron Ore Prices

The Australian dollar is the worst performing currency this week.  It has lost about 3.5% against the greenback.  This is its worst week in a little more than a year.  

Given that the dollar bloc and yen are the weakest currencies, it would seem to contradict recent media reports about how the carry trade is back.  Carry trades by definition based on rate differentials not currency movement.  High yield currencies can be bought on the basis of momentum not carry.  Similarly the yen can be sold on momentum not simply as a funding currencies.  

Note that the Aussie's slide this week wipes out a year or more of carry.  Australia's 10-year bond yields 3.60% and the 2-year yields 2.65%.  

Some observers are attributing the slide in the Australian dollar to the decline in iron ore prices.  Iron ore prices have fallen by 40% this year.  This Great Graphic, created on Bloomberg, shows the Australian dollar (white line) and iron ore prices (yellow line).   It offers little evidence to support the conventional wisdom.  It seems like a convenient rather than factual explanation.  

From a methodological point of view, for high income countries, capital flows are more important for determining currency movement than trade flows.  Capital markets are bigger than the market for tradeable goods.  We note that although speculators in the futures market were net short euros, yen and Swiss francs, they were long the dollar-bloc currencies and sterling.  Part of this week's sell-off in the Aussie (and Canadian dollar) was likely the exit by stale longs in the face of strong US dollar. Kangaroo bonds (Aussie denominated bond by foreign issuers) have been very popular this year.  

The Australian dollar has also emerged as a minor reserve currency.  This status is also not a function of the price of its important export.  It is a AAA credit with a relatively high yield, which offers reserve managers an attractive diversification vehicle.  

Measures of purchasing power parity, like the one the OECD uses, estimates the Australian dollar is significantly over-valued.  The OECD estimates that the Aussie is about 27% over-valued, behind he Swiss franc (~33% over-valued) and the Norwegian krone (~30% over-valued).  These models also seem to place (undue) place on relative prices of goods.  The decline in the Australian dollar is a welcome development for the RBA.  If the decline is sustained, it may reduce the likelihood of another rate cut, which several Australian banks reportedly anticipated in the first part of 2015.  

Great Graphic: Australian Dollar and Iron Ore Prices Great Graphic:  Australian Dollar and Iron Ore Prices Reviewed by Marc Chandler on September 12, 2014 Rating: 5
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