Everything is pointing to a bumper year for the Aussie

ALTHOUGH recent concerns of a Chinese asset bubble and fears of a double dip recession have had some effect on Australia, the country has been outshining the other advanced economies throughout the financial crisis. Similarly, the Australian dollar has been among the best performing currencies this year. <br /><br />The Australian dollar is up 22.3 per cent year-to-date against the US dollar. Even more impressively, it is up 37 per cent since the market bottom in March. Only the New Zealand dollar has been stronger then the Aussie against the greenback. Should Australia continue to strengthen and the current global recovery continue on course, then we may see further upside to come for the Aussie dollar. <br /><br />It would be tempting to see Aussie dollar strength as stemming from US dollar weakness. Fiscal deficit concerns, reserve diversification, near-zero interest rates, and a rebound in risk appetites have certainly all put pressure on the buck across the board over recent weeks. <br /><br />But Aussie strength has not been limited to the US dollar. Against the top 16 global currencies year-to-date, Aussie is stronger against all but the Brazilian real and the South African rand. Compared to most of the others, it is up by 10-20 per cent.<br /><br />Aussie strength stems from a variety of sources, most of which look likely to continue to provide support in the year ahead. Firstly, Australia was one of the few major global economies to have escaped the global recession relatively unscathed, experiencing only one quarter of negative GDP growth in the last three months of 2008. Even that was only -0.7 per cent. Australia implemented an AU$42bn (&pound;22bn) stimulus package earlier this year, and so far it has prevented near-term contagion from the global recession. That stimulus package will continue to resonate into 2010.<br /><br />Secondly, Australia&rsquo;s role as a key commodity producer and its geographical proximity to Asia, and China in particular, have underpinned the Aussie dollar. On a regional basis, Asian economies have been among the best performers throughout the global downturn and most of them remain well-positioned to lead the way into the global rebound, however weak it may be compared to pre-crisis levels. Regional growth outlooks for Asia and attendant commodity demand suggest that the prospects for Australian producers remain solid, which will also be supportive for the Aussie. The Aussie is correlated positively with commodity prices, and as long as the global recovery continues, commodity prices should remain supported, providing Aussie with a virtuous feedback loop.<br /><br /><strong>BENCHMARK RATES</strong><br />Thirdly, the Aussie has also benefited from higher relative interest rates. Despite the Reserve Bank of Australia (RBA) having cut benchmark rates to a historical low of 3 per cent, Aussie base rates are still the highest in the G10. <br /><br />Looking ahead, the RBA is widely expected to be among the first of the major central banks to raise rates, perhaps before year-end, but in the first quarter of 2010 at the latest. The RBA is also expected to raise rates rather quickly, with most forecasts focusing on an initial hike of between 50-100 basis points and a total rate increase of about 200 bps by the end of 2010. <br /><br />In contrast, other major central banks are likely to keep interest rates on hold for most of 2010, or tighten only modestly. As a result, relatively high, and widening, interest rate differentials look to provide the Aussie with another source of support.<br /><br />But traders should be cautious in the short-term. The positive outlook for the Aussie is inextricably intertwined with the prospects for a global recovery. Should global growth begin to falter significantly enough, then the Aussie will pay a price. <br /><br />Global financial market trajectories, which are separate from the underlying economic developments, also pose another risk to further Aussie appreciation. The current risk rally in stocks and commodities is over-extended and ripe for a correction, although it may not be until third quarter corporate earnings reports are delivered in mid-October that a decent-sized pullback materialises. With that in mind, and with the Aussie dollar having strengthened significantly already this year, in the short-term traders should be reluctant to chase it higher from its current highs for the year &ndash; around 0.8750 against the US dollar. <br /><br />Instead, they should look to buy Aussie on pullbacks into the 0.7700/0.8000 area, which is about 10-12 per cent below current levels. Also, one risk to watch closely is any indication that the RBA is intervening to stem Aussie strength. The RBA has been a stealthy operator in the past and was last reported to be active in the 0.8100/0.8250 area, though it seemed clear at the time their interest was to slow rather than to cap Aussie gains. Similar interventions ahead may provide a buying opportunity.<br /><br />But with Australian strength seemingly unshakeable, how high can Aussie go over the next year? The recovery year-to-date has already exceeded 61.8 per cent &ndash; a key Fibonacci retracement &ndash; of the 2008 collapse, from about 0.9850 down to roughly 0.6000. This sets up the 76.4 per cent retracement at about 0.8950, together with psychological, and perhaps RBA, resistance at 0.9000 as the next major upside hurdle. Beyond that, last year&rsquo;s highs around 0.9850 could ultimately be exceeded with Aussie eventually exceeding parity against the US dollar later in 2010. <br />Brian Dolan is chief currency strategist at<br />