Understanding Australian Dollar Fundamental Bias – Educational Report:
- The Australian Dollar is influenced by sentiment, commodity prices and monetary policy
- From 2011 - 2023, RBA vs Fed policy became a poorer predictor of AUD/USD direction
- More focus was placed on financial market sentiment heading into the global pandemic
- The surge in Australia’s trade balance post-Covid made commodities a key AUD driver
Like other exchange rates, AUD/USD can be influenced by the difference in relative monetary policy, which in this case is between the RBA and the Fed. But that alone is one of the many ingredients that drive the direction of the Aussie. Financial markets are constantly adapting to changing economic environments. That also means the importance of what impacts the Australian Dollar changes over time.
For example, another ingredient that influences AUD/USD is financial market sentiment. That is because Australia finds itself sitting at the front end of the global supply chain, or in other words, the world business cycle. That is why you will often see the exchange rate being influenced by stock markets, especially those related to Emerging Markets.
China is Australia’s largest trading partner, and the latter heavily exports commodities to the former. That also means that understanding the dynamics of commodity prices is another factor that determines Australian Dollar direction. This means three vital ingredients are impacting the exchange rate: relative monetary policy, market sentiment and commodity prices.
With that in mind, this is a special report that focuses on trying to understand how the influence of these variables on the Australian Dollar changed from 2006 up until the middle of 2023. The purpose of the study will be to demonstrate why it is important to adapt fundamental analysis to constantly changing environments. With that in mind, let us cover how this was performed.
How the Study Was Conducted
Rolling regression modeling over a 36-month window in steps was used on the following variables (all of which were expressed in month-over-month form): AUD/USD, the spread between Australian and United States 2-year government bond yields, the MSCI Emerging Markets Index (EEM) and the Bloomberg Commodities Index (BCOM). Doing this created explanatory coefficients that changed in influence over time. It should also be noted that to gauge underlying relationships, a few data outliers were removed. If you are interested, a full analysis of how this was performed was outlined in a Twitter thread.
How Has RBA & Fed Policy Divergence Been Influencing AUD/USD?
We will start with the importance of relative monetary policy. The dark red line on the chart below is the rolling bond yield spread coefficient and how it changed over time. When this line is rising above 0, that means a 1 percentage point improvement in 2-year bond yield returns in Australia relative to the United States produced an increasingly more positive reaction from AUD/USD (m/m), controlling for EEM and BCOM.
In other words, increasingly higher interest rates in Australia relative to the United States typically means stronger Aussie appreciation. What you may notice is that the dark red line has been falling steadily since 2011 and turned slightly negative around the time of 2020. When the dark red line is at 0, that means there is practically no relationship between AU-US bond yield spreads and AUD/USD.
So, what happened to this relationship? The yield advantage that Australia once had relative to the United States slowly evaporated after the 2008 Financial Crisis (light red line), turning negative heading into Covid and remaining mostly thereafter. In other words, interest rates in the US became higher than in Australia. As this happened, the ability of RBA monetary policy to influence AUD/USD (through setting interest rates) weakened significantly and remained so in the few years after Covid.
How Has Emerging Market Sentiment Been Impacting AUD/USD?
While RBA policy became an increasingly poorer predictor of AUD/USD, Emerging Market sentiment became more important. The dark green line on the chart below is the rolling EEM coefficient. When this line is rising above 0, a 1 percentage point boost in monthly Emerging Market performance shows increasingly better returns in AUD/USD (m/m), controlling for bond yield spreads and BCOM.
I have overlaid this with G4 central bank balance sheet assets. What you can see is that as major central banks injected liquidity into the financial system after the 2008 recession, sentiment became an increasingly better predictor of the Aussie exchange rate. But, you might notice that the dark green line peaked just before Covid and stayed lower thereafter despite the surge in asset holdings.
That would speak to less influence from market sentiment driving AUD/USD in the post-Covid era (although the relationship remained positive). Let us take a closer look at why this happened.
What About Commodity Prices?
The dark blue line on the chart below is the rolling BCOM coefficient, zoomed in on just 2016+. When this line is rising increasingly above 0, a 1 percentage point boost in the BCOM Index tends to elicit a stronger positive effect on AUD/USD (m/m), controlling for bond yield spreads and EEM. What is very interesting is that the dark blue line surged higher heading into Covid and remained elevated thereafter.
This is as Australia’s trade balance exploded during Covid, meaning the value of the nation’s exports became significantly larger than its imports. In other words, as commodity prices surged, benefiting Australia, AUD/USD paid more attention to the BCOM Index and less so to EEM and AU-US bond yield spreads.
A Closer Look at Post-Covid
The last chart below plots the EEM and BCOM coefficients zoomed in on 2016+. The reason this was performed is to visualize the evolution of AUD/USD underlying fundamental dynamics during Covid. Specifically, you can see how entering the pandemic, commodities became a more important factor than Emerging Market sentiment for driving the Aussie exchange rate. This was likely due to the significance of how global trading and surging prices impacted Australia’s economy, and thus the exchange rate.
Conclusion and Study Limitations
While it is generally correct that monetary policy is a key driver of exchange rates, the truth is each currency behaves differently because of the unique traits of various economies. For the Australian Dollar, sentiment and commodity prices are other key factors that are involved in this equation.
On top of this, fundamental conditions change, and the influence of certain variables is no different. What this study has demonstrated is that for the Australian Dollar, RBA policy direction became an increasingly poorer predictor of the exchange rate in the aftermath of the 2008 financial crisis.
Instead, factors like market sentiment and commodity prices become better predictors of the exchange rate as underlying fundamental conditions evolved heading into Covid. Perhaps this could reverse course in the future, such as in a scenario where interest rates in Australia begin far outpacing those in the US.
It should be noted that this kind of modeling with rolling regressions creates many outputs, 180 to be exact in this sample. That is 180 different regressions that could each have their quirks or issues, such as creating a coefficient that is not statistically significant.
This was not considered. Instead, a general comprehensive regression of the entire dataset was thoroughly analyzed for potential issues. This included testing for correlation between control variables, residual normality, residual autocorrelation and heteroskedasticity. No major faults were identified.
If you would like to learn more about the Australian Dollar, check out the complete report here.
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--- Written by Daniel Dubrovsky, Senior Strategist for DailyFX.com
