“The AUD has been caught in a perfect storm it would seem, but then the balance of risks suggests every possibility it could soon blow over,” - BNY Mellon.

Those looking for a stronger Australian Dollar should exercise patience over coming weeks as the current period of underperformance has a limited shelf-life argue analysts with BNY Mellon.

The difference between Australian and US bond yields has been key to recent price action in the Australian currency and how strong an influence this driver will be going forward is key to the Aussie’s likely performance in the weeks and months ahead.

“While politics may be key to gauging the performance of many currency pairs right now, it is notable that the AUD’s 6% slide against the USD began as Aussie/US Treasury yield spreads topped out in the autumn, since which time they have ceded 39-57 bps across the curve, taking them to levels not seen since the turn of the millennium,” says Neil Mellor, a senior currency strategist at BNY Mellon.

Yields - the coupon paid on Government-issued debt in the US and Australia - have long been supportive of the Australian Dollar as Australian yields have long been superior to US yields.

This creates an incentive for investors to borrow in Dollars and invest in Australia where the return is better. However, this incentive has been declining of late, depriving the Australian Dollar of a key support.

After topping out just north of the $0.8100 threshold in early September, the Australian Dollar has fallen around 6% against the greenback, aided by a narrowing gap between Australian and US bond yields.

“The pull of yield has been considerable for some time,” says Mellor. “While pre-crisis weekly correlations suggest only a loose relationship between yields and AUD/USD (35-48% correlation since 2000), since 2010 they have risen to a substantial 78-82%.”

When the additional yield offered to investors holding Aussie debt falls, it can reduce the relative attractiveness of Australian bonds and therefore, the Aussie currency.

“The AUD’s performance therefore reflects a retracement in yields whose uptrend got underway in the Australian winter, amid growing confidence in an economy with a robust jobs market at its heart,” Mellor explains. “Yields have since retreated in the face of modest inflation outturns, the worldwide puzzle that is modest wage pressure and a continued nervousness about housing.”

Hopes of an Australian interest rate rise in the near future have faded, a negative for the currency, at a time when US yields have risen after the Federal Reserve used its September policy statement to reaffirm its commitment to raising the Federal Funds rate in the US.

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Watching Iron Ore Prices

And then there is the price of iron - Australia's main export and foreign currency earner; iron ore prices have been on the slide of late, again depriving the Aussie of support.

“Certainly China, Australia’s largest trade partner and driver behind the price of its principle produce, constitutes a double-edged sword,” says Mellor. “Amid an economic slowdown led by a housing market that is being forcibly tamed, questions surround the "Beijing put", or what a reformist Chinese government is now prepared to do in terms of expansionary policy.”

Out of concern for financial stability, Chinese policymakers are in the midst of an attempt to wean the economy off of the fiscal steroids that propelled its growth in prior years.

This means a lesser rate of government-funded infrastructure development than in the past, which is set to reduce China’s need for hard commodities such as iron ore, Australia’s number one export.

“Clearly, this could be a boon or bust for the AUD, but then, if there are genuine concerns about China, they are not being reflected in commodity prices – at least not yet,” Mellor notes.

Raw materials prices have been sclerotic in recent months, with iron ore futures dropping more than 25% since the height of summer, while copper, oil and coal prices have risen substantially.

One explanation for this is that price action has been the culmination of Chinese environmental policy changes taking place against a backdrop of rising global growth.

China has mandated the closure of some of its most polluting steel mills over the winter period, which may have hit expectations for iron ore demand, while solid growth and hopes of a continuation of Organization of Petroleum Exporting Countries efforts to stabilise global oil supply have driven other prices higher.

The takeaway from this confluence of price action could be that underlying economic fundamentals remain solid across much of the developed and emerging world, which should be supportive for the Aussie Dollar, while pockets of disruption (steel mill closures) are simply muddying the waters a touch.

Politics is Not Insignificant

“Perhaps the biggest downside AUD risks to ponder are the intangible type. Alongside the RBA’s clear inclination toward a more competitive currency – the restatement of which always has the potential to move the market – there is also a political ‘crisis’ underway,” flags Mellor.

Those holding dual citizenship are banned by the Australian constitution from holding public office. Australia’s ruling Liberal Party, which governs in a coalition with other “centre-right” parties, lost its one-seat majority last week, with the dismissal of deputy Prime Minister Barnaby Joyce.

Revelations of dual citizenship had claimed eight lawmakers at the point of Joyce’s expulsion from the senate but, Thursday, saw another lawmaker fall victim to the growing scandal.

“The AUD has been caught in a perfect storm it would seem, but then the balance of risks suggests every possibility it could soon blow over,” says Mellor.

Skye Kakoschke-Moore, a senator with the Nick Xenophon Team, resigned overnight after discovering she is a dual British national. The NXT team are not part of the governing coalition and the resignation doesn’t affect the government’s already-weakened position in the lower house.

However, by elections scheduled for December 02 and December 16 will be crucial to determining whether the coalition will recover its majority or be condemned to minority government.

“Technical levels may prove to be pivotal: a head and shoulders pattern formed from July to October perhaps points to a further retracement below 75 cents; but then, the pair bounced convincingly off its Q1 2015 low on Tuesday. Patience is clearly the prudent approach,” Mellor concludes.

The Australian Dollar was quoted higher against much of the G10 basket Thursday, with the AUD/USD rate marked 0.20% higher at 0.7628 and the Pound-to-Australian-Dollar rate called 0.26% lower at 1.7444.

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