What Causes Volatility In The Australian Dollar?

History

Dating back to its official inception in the early 20th century, the Commonwealth of Australia has employed several different forms of currency. During the early years of the commonwealth, Australia saw fit to adopt a monetary system based upon that of Great Britain.

Australian pounds, shillings and pence were used to facilitate trade, much as they were being used in Britain. However, in the mid-1960s, Australia made the transition to a decimal-based monetary system and eventually settled with the creation of the Australian dollar, which you can learn more about here.

Fundamentals

The Australian economy is ranked 20th globally in terms of the purchasing power of its gross domestic product, also known as its purchasing power parity. Government policies encouraging free trade have enabled Australia to capitalise on its central trade location and abundance of natural resources.^[1] The service and export sectors represent the largest portions of Australia's economic output. The service sector is dominated by financial services such as the facilitation of investment activities, distribution of insurance products and the provision of banking functions. The exportation of energy and foodstuffs make up a sizeable portion of the export sector.

The Australian dollar is actively traded on the forex market via currency pairings, and in isolation through the buying and selling of outright futures contracts on the CME Globex futures exchange. Often referred to by its nickname the "aussie," the Australian dollar is considered to be one of the world's eight major currencies.^[2]

On the forex market, the Australian dollar's pairing with the U.S. dollar, represented as AUD/USD, is considered to be a major pairing. Being considered a major pairing denotes that the currency pair trades with high volume and liquidity on a regular basis. Other currency pairs that commonly include the Australian dollar concern the euro (AUD/EUR), Canadian dollar (AUD/CAD), Japanese yen (AUD/JPY), and the New Zealand dollar (AUD/NZD).

The Reserve Bank Of Australia

Exchange rate volatility is an issue that faces every currency periodically. For a large-scale exporter of goods and services such as Australia, it is imperative that the volatility is actively addressed and managed. The task of managing Australia's currency has been delegated by parliament to the Reserve Bank of Australia, also known as the RBA.

To manage the volatility of the Australian dollar, the RBA establishes a periodic target inflation rate, with an acceptable rate falling between 2% and 3%. Accordingly, the interest rate on overnight money market loans to other lending institutions, or "the cash rate," is adjusted to reflect current inflationary concerns.

Economic indicators such as the Consumer Price Index and Producer Price Index are of paramount importance when establishing the target inflation rate, and indirectly influence the valuation of the Australian dollar. The RBA makes an announcement regarding its interest rate policy on the first Tuesday of every month except for January.^[3]

Intraday Volatility: Economic Releases

On an intraday basis, the release of official economic reports from the Australian Bureau of Statistics can cause violent fluctuations in the exchange rate of the Australian dollar. Quarterly reports concerning economic indicators such as gross domestic product (GDP), the consumer price index (CPI), and the producer price index (PPI) can sway short-term exchange rates immediately upon their release. Monthly economic releases such as the Labour Force Survey, retail sales, and merchandise trade statistics can also influence short-term exchange rate valuations.

In addition to the economic data releases, the Reserve Bank of Australia also causes intraday exchange rate volatility during their monthly announcements regarding levels of inflation and current interest rate policy. Each one of these economic data releases has the potential to create large spikes in intraday volume, which in turn results in the extreme fluctuations of short-term exchange rates.

The proliferation of high-frequency trading within the current electronic marketplace can also magnify short-term volatility. Large institutional investors employ fully automated momentum algorithms, which become active upon market conditions meeting specific criteria. For instance, a high-frequency trading strategy based upon volume spikes and pricing momentum can make thousands of trades in a single second. The implications of the high-frequency trading practices currently taking place within the forex and derivatives markets are still very much a mystery. However, when coupled with an external stimulus such as an economic data release, the implementation of high-frequency trading strategies can increase volatility exponentially.

Intermediate Term Volatility

Time horizons concerning the investment and trading of a financial instrument tend to provide more stability as they lengthen. In contrast to intraday volatility, in which price fluctuations are measured in minutes or seconds, intermediate term volatility is measured in days, weeks and months. The drivers of intermediate term volatility for the Australian dollar are fundamental in nature, and have to do with the major components of the Australian economy.

A good illustration of how the aussie's exchange rate can be influenced by a fundamental economic force within the intermediate term is through the examination of Australia's largest trade partner, China. The selloff of China's equity markets and subsequent devaluation of the Chinese yuan had an impact on the Australian dollar's volatility.

From the period of Jan. 4 to Jan. 6, 2016, AUD/USD underwent a sharp market correction of 200 pips to the bear. During this period, the pricing of AUD/USD ranged from .7283 downward to .7083. This fluctuation in value represents an intermediate range two-month low for AUD/USD.^[5] Although situations regarding trade partners are constantly evolving, this example sheds some light on the relationship between the Australian dollar and the performance of the Chinese economy.

Commodity pricing is another driver of intermediate-term volatility concerning the Australian dollar. The current market value of key exports such as crude oil and natural gas can have a serious impact on the currency's exchange rate. The Australian dollar is considered an "oil proxy," as its value can increase or decrease rapidly as crude oil valuations fluctuate.^[6]

Summary

At its core, the Australian dollar is a "floating currency"; its value is determined by the participants within the global currency markets at a given time. Of course, past performance is no indication of future results. Uncertainty in the economies of its trading partners, as well as fluctuations in commodity pricing, can be lynchpins in the intermediate-term exchange rate volatility faced by the Australian dollar.