The Australian dollar (AUD) is characterized as being commodity linked. It is especially correlated to the values of the gold. This dependence has been caused by Australia’s status as the world’s third largest producer of gold and the vast quantities it exports each year. As the prices of gold and commodities increase the value of the Australian dollar also rises. The opposite movement is also observed when the corresponding prices of commodities fall.
The steep increase in the commodity prices leads to rise in inflation concerns to which the Reserve Bank of Australia (RBA) usually responds by increasing interest rates as a way to combat potentially high inflation levels. However, since gold prices tend to increase when global economic or political uncertainties occur, the policy of increasing interest rates is addressed with caution. The reason for this is the potential spillover effects that may affect the Australian economy.
The interest rates observed in Australia are one of the highest among the developed countries. This, combined with the high liquidity of the AUD$, has led to its wide popularity as a carry trade currency. Since most investors are after high yields, the value of the AUD$ significantly increases as a result of its high demand.
A decrease in the positive interest rate differential between the AUD$ and other countries will be observed when global central banks attempt to increase their interest rates. Under such conditions, carry traders will close their positions, which will eventually lead to the selling of the AUD$.
Forex market participants are interested in the interest rate differentials between the short term interest rate yields of industrialized countries and the Australian cash rates. The reason for this is that these differentials serve as indicators for the potential money flows. The latter demonstrate the amount of yield that is received by short term fixed income assets denominated in AUD$ over foreign short term fixed income assets. Since investors seek assets that provide highest yield, the differentials are useful in gauging potential currency movements.
The commodity oriented currency increases its dependency on conditions that may have either positive or negative effect on the production of goods. As a result any severe weather conditions can lead to deterioration in the production activities. Bad weather conditions in 2002 led to the worsening of the farming activities since a severe draught was experienced during those times. The importance of this is highlighted by the fact that approximately 3% of Australia’s GDP is contributed by farming. The related industries that serve this sector were also affected by the negative conditions.
Nevertheless, such events are not separate instances in the economic history of Australia and the country has on many occasions managed to recover.
