AUD goes from worst to first

After being very close to the worst performing currency in the year to the end of August, the Australian dollar has strengthened around 5% against the USD and 4% on a trade weighted basis.  This uplift is only second to the Kiwi.

There has been a couple of factors which have helped drive the bounce, although pressure still seems to be for a weaker AUD in the medium term.

Firstly, Chinese economic statistics have tended to surprise to the upside in the last couple of months and bulk commodity prices have tended to improve.

The price of iron ore, Australia's largest export, is up around 19% from the lows reached in June.   Iron ore bottomed much earlier than the AUD and has managed avoid the seasonal route seen last year with steel production remaining healthy.

Leading indicators have also been good, with the Chinese flash PMI pretty good in September, as shown on the chart on the left.

Second, domestic economic data has been a little better as well.  Measures of confidence have bounced following the Federal election, with there signs that monetary policy is getting increasing traction in housing markets in particular.  While this doesn't necessarily suggest the worst has now past the Australian economy, it does suggest the economy isn't currently being dragged into a recession by falling mining investment.

This has helped yields rally in the Aussie's favour in the last month or so.  The relationship between yields at the AUD is slippery.  In some ways it seems that the AUD has become more sensitive to movements in yields since the markets first started to price in the possibility of a rate cut in May.  The rally in the AUD relative to the USD has coincided with a ~40 widening of the spread between the respective 2yr government bonds.

While it doesn't seem a reversal in fortune is imminent for the AUD, its likely that the AUD will be lower in 3-6 months time.  First, Chinese economic data is likely to remain decent for a while, but the policy risks are rising given the balance of growth is not what policy makers are really aiming for.

Second, it is too early in my mind to call the all clear on the Australian economic outlook.  While interest rate sensitive sectors have improved, these are much more visible on a month to month basis, things like business investment are much harder to get a handle on.  The overall performance of things like confidence indictors would suggest that weaker business investment has yet to severely undermine the broader economy, but this is still a big risk.

Finally, the AUD is not particularly weak given the headwinds facing the economy, with the RBA making it clear that they would be more comfortable if it were lower.