NAB: Why the Australian dollar is rallying and could move above 78 cents

Photo by Yuli Seperi/Getty Images

Even with the 1%-plus decline registered on Monday, the Australian dollar has been on an epic run higher of late. It just recorded its largest two-week rally since against the US dollar since late 2011, extending its climb from the lows struck in mid-January to over 10%.

While there have been plenty of theories put forward to explain the Aussie’s ascent – the spike in the iron ore price, less chance of rate hikes in the US, the rebound in the crude oil price and technical analysis just to name four- the NAB’s global FX strategy team, led by Ray Attrill, believe they have the definitive answer: a substantial drop in market volatility.

“The key driver has not been shifts in interest rate differentials, albeit Australian rates have moved slightly in the AUD’s favour since the Q4 GDP outcome reported the week before last,” says the NAB.

“Rather it has been the improvement in global risk sentiment and as proxied by the fall in the VIX, an option-implied measure of downside volatility in the S&P 500. At 16, the VIX now trades at well below its long term average of near 20 and has been more important than the bounce back in commodity prices in driving up the AUD’s fair value, albeit the latter has also been supportive.”

The VIX measures market volatility in the US S&P 500 stock index based on call and put option pricing. It has earned the unenviable nickname as Wall Street’s “fear gauge”, with higher readings indicating that investors anticipate heightened levels of market volatility in the 30 days ahead.

As market volatility drops, risk assets tend to outperform. As a well known proxy for investor sentiment, the Australian dollar is at the top of that list.

The chart below, supplied by the NAB, reveals the contributing factors in the recent recovery in the NAB’s Australian dollar fair value model. Based on their assessment, the drop in market volatility has been the major driving force behind the recent rally in the Aussie.

While the NAB, like many others, predicts that the Aussie’s move higher won’t last, forecasting that the AUD/USD will still finish the year buying 67 cents, in the near term it suggests that “it is going to take some sort of shock” for the AUD/USD not to approach or test the .7830/80 level.

That would be another 4% higher than its current trading level of around 75 cents.

The upcoming US FOMC rate decision, scheduled for 5am AEDT on Thursday, will likely act as the first test for the NAB’s bullish call.

While no rate hike is expected, the tone of the accompanying monetary policy statement, along with updated economic and rate forecasts offered by the Fed, will likely make-or-break the Aussie dollar rally, at least in the short term.

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