<strong>JANE FOLEY<br />RESEARCH DIRECTOR, FOREX.COM<br /></strong><br />FOR most of the past 12 months there have been strong correlations in the market within the group of assets that are commonly described as &ldquo;risky&rdquo;.&nbsp; More recently there have been signs that many of these correlations are breaking down or weakening.&nbsp; This should not be surprising.&nbsp; It implies that investors are feeling sufficiently confident to start judging each market by its relative merits. Despite its gains this year, the Australian dollar is likely to continue benefiting from this process. <br /><br />The correlation between oil prices and, on one hand the Australian and US dollars, and on the other the S&amp;P 500, were particularly strong from summer 2008 until recently, ie the period roughly including the height of the financial crisis and the 12 months afterwards. During this period stress in the financial market was reflected in many different ways, including the persistence of heightened money market rates. The latter have subsequently relaxed. This factor &ndash; combined with the much lower-than-expected demand for liquidity in last week&rsquo;s second ever European Central Bank 12 month tender &ndash; suggests that the banking sector is returning to health. <br /><br />Coincidentally, last week the IMF revised lower its estimate for global write downs on loans and investments by 15 per cent, a revision which reflects its higher estimate for global growth next year. Over time conditions in the financial markets are returning to normal, and this is bringing a reassessment of risk.&nbsp; <br /><br /><strong>CONFUSION AND CHAOS<br /></strong>The confusion and chaos caused by the financial crisis resulted in a simplified attitude towards risk, with instruments being fairly cleanly considered as either risky or safe. Stocks, oil and the Australian dollar have been prime examples of &ldquo;risky&rdquo; assets this year, and this is described by the correlations that persisted between them. Bonds, the American dollar and the Japanese yen dominated the safe haven camp. <br /><br />A normalisation of conditions in the financial markets should see markets driven increasingly by domestic economic fundamentals and less so by general swings in attitudes towards risk. <br /><br />Many of this year&rsquo;s correlations should come apart at the seams, suggesting that oil and currencies are likely to play greater heed to their own fundamentals and less to those of the stock market. <br /><br />Since the middle of this year oil prices have been unable to keep pace with the gains in the Australian dollar/US dollar pair. While the potential for further oil price gains has been offset by the weight of supply, confidence in Australian economic fundamentals has gone from strength to strength. Despite its heady levels, the Aussie is likely to remain well underpinned by investment flows. Australia&rsquo;s four main banks are among less than a dozen banks in the world to hold on to their AA rating. <br /><br />And alongside oil-rich Norway, Australia could be one of the very few economies to see its central bank raise interest rates before the end of this year. While the rhetoric of most other G10 central banks continues to be laced with a heavy degree of caution with respect to the nature of the economic recovery into 2010, the Reserve Bank of Australia is tangibly more certain of its upswing. <br /><br />Australia has managed to avoid technical recession altogether and last week RBA Governor Glenn Stevens described the impact of the global recession and financial crisis as resulting in a &ldquo;mild downturn&rdquo; in Australia.&nbsp; Its geographical proximity to China continues to serve it well. Latest export data (July) show a 5 per cent month-on-month rise in metal ores and minerals which is helping offset weakness elsewhere in the export sector. <br /><br />There are signs that Australia&rsquo;s unemployment rate (a lagged indicator of a downturn) may have already peaked at 5.8 per cent. US and UK unemployment rates by contrast are expected to continue rising into next year.&nbsp; <br /><br />While Australia&rsquo;s strong banking sector and economic fundamentals suggests the Aussie should maintain a position of strength, a short US dollar position may not be the best medium to express it. The US dollar has found renewed favour recently on fears that the recovery outside Asia may be slow and bumpy. The reassertion of both US and Eurozone officials of their support for the US Treasury&rsquo;s strong dollar policy has also curbed dollar selling over the past week or so. <br /><br />Sterling, by contrast, is bogged down by fears that more quantitative easing might be announced, and by the government&rsquo;s huge budget deficit and implied potential for credit difficulties. <br /><br />The recent correction higher in the pound/Aussie pair could prove a good opportunity to take a short position.&nbsp; <br /><br />