Forex Investment and Currency Trading

AUD/CAD has found stability around 0.80 after plunging 20% between July and October. Global equities followed a similar trend, suggesting that equities might have supplanted rate spreads as a key driver of AUD/CAD. Indeed, the correlation between equities and AUD/CAD has increased significantly through Oct 2008. However, this tighter correlation did not come at the expense of interest rate spreads but rather reflected a critical underlying concern that was driving both the equity sell-off and the narrowing AU-CA spread: fear of a protracted global recession. Not surprisingly, the correlation between AU-CA 2-yr spreads and the MSCI world equity index increased to a staggering 74% during this period as the two trends reinforced intensifying global growth concerns.

As commodity currencies, both AUD and CAD are dependent on the global business cycle and normally move in loosely correlated trends against the majors. But the timing, magnitude and intensity with which these currencies react to the global cycle diverge frequently because of distinct export commodities and export destinations. The drop in AUD/CAD during Sept and Oct reflected this. While both currencies depreciated sharply against USD, AUD/CAD underperformed as growth concerns spread from the industrialised nations (including the U.S., destination of almost 80% of Canadian exports) to emerging markets and more specifically Asia, destination to more than half of Australia’s exports, Japan included.

Interest rate expectations tend to capture the above-mentioned differences and as a result rate spreads have been and continue to be a strong predictor of AUD/CAD. The daily correlation between AUD/CAD and 2-year spreads has been a tight 63% since 2000 and dwarfs the 10% correlation between the currency pair and global equities. Even through the current crisis that started in July 2007, spreads have continued to dominate, with correlations changing to 78% (spread) and 39% (equities) respectively. The strong link between AUD/CAD and rate spreads tightens even further if the spreads are adjusted for FX volatility to reflect a risk-adjusted interest rate. The usefulness of this method has increased considerably since volatility exploded since the end of Aug. Three-month USD/CAD vols jumped from 9.5% to 20%, AUD/USD vols were up from 12.5% to 27.5% and AUD/CAD vols rallied from 11.5% to 23%.

Moving into early 2009, Canadian rates are expected to bottom sooner than Aussie rates as the North American business cycle bottoms ahead the rest of the world, probably in H2 2009. AU–CA rate spreads are thus expected to move moderately lower favouring further AUD/CAD weakness even if equities bottom in the near future. However, the risk remains tilted to further growth weakness in Asia, deeper rate cuts in Australia and another sharp leg down for AU-CA rate spreads, dragging AUD/CAD towards 0.75.