Hike in interest rates boosts prospects for Aussie dollar

THE hike in rates to 3.25 per cent yesterday by the central bank of Australia should have come as little surprise to most market participants. Over the past couple of months, there have been growing indications, not least from the Reserve Bank of Australia (RBA) itself, that a rise in the cost of borrowing was impending. And although the consensus was for a hike in November, the local press had already been pointing to the possibility of a move in October ahead of the meeting. <br /><br />The RBA is the first central bank of the most advanced economies to tighten its monetary policy in the wake of the financial crisis. The news of the hike boosted the Australian dollar against the US dollar to a 14-month high of US$0.883 as investors scrambled to price in at least one more increase by the RBA this year, following hawkish rhetoric from the central bank. <br /><br />So what does the start of policy tightening down under mean for currency traders? We are certainly going to see further hikes from the Australian central bank &ndash; note yesterday&rsquo;s comments from the RBA saying &ldquo;it is now prudent to begin gradually lessening the stimulus provided by monetary policy&rdquo;. <br /><br /><strong>COMMUNICATING INTENTIONS</strong><br />This ought to boost the Aussie dollar against a broad basket of its trading partners, but as Mark O&rsquo;Sullivan at forex provider Currencies Direct notes, the RBA is very good at communicating its intentions, with the result that any further moves may well be priced in before they happen. Trading in overnight index swaps indicates that traders are pricing in the likelihood that the RBA will raise rates by 175-200 basis points over the next 12 months.<br /><br />However, traders will be pleased to hear that there should still be plenty of opportunities to go long on the Aussie dollar in the near future. O&rsquo;Sullivan says: &ldquo;There is potentially room for some profit-taking at the moment but this is just going to give people better levels to get back into long positions in the Australian dollar.&rdquo;<br /><br />In his opinion, the Australian economy will continue to benefit off the back of Chinese expansion and the only reason why the Aussie would fall back would be a decent shake out in equities or a significant return of risk aversion to the markets. <br /><br />Australia&rsquo;s economy and currency are closely linked to commodities and the Chinese are keeping the demand &ndash; and the price &ndash; for basic materials high by using any dips in price to stockpile. This is proving very beneficial for the Aussie dollar. <br /><br />&ldquo;The Australian economy is in a sweet spot at the moment and is the perfect economy right now &ndash; the Aussies are at least 12 months ahead of everyone else in their recovery cycle,&rdquo; O&rsquo;Sullivan says. <br /><br />But any currency traders &ndash; and carry traders in particular &ndash; expecting interest rates to be hiked sharply over the coming months will be disappointed. Simon Derrick at asset management firm BNY Mellon says: &ldquo;Even for the RBA, there is no question of anything but a slow and steady withdrawal of emergency measures (particularly as growth will suffer from an inevitable withdrawal of fiscal stimulus).&rdquo;<br /><br />However, carry traders should be pleased by the continued weakness of the US dollar &ndash; which has become the funding currency of choice for such trades &ndash; and the growing strength of the Aussie. <br /><br /><strong>BEST RETURNS</strong><br />Other central banks may follow the RBA in hiking rates, but for now, foreign exchange traders using carry strategies can rest assured that, of the major economies, Australia will still offer the highest interest rates and this will support its currency, especially against the US dollar.<br /><br />However, more contrarian currency traders might also want to look at the sterling-Aussie pair, suggests Currencies Direct&rsquo;s O&rsquo;Sullivan. Given that the Aussie dollar is now at a 15-year high against the pound, he thinks that there is potential for sterling to make some gains against the Aussie if the UK economy improves next year. Those betting on a UK recovery could look to take out a medium-term short on the Australian dollar against the pound at the current high levels. <br /><br />Despite concerns over a Chinese asset bubble, the Australian economy has remained remarkably resilient to the global recession and the financial crisis. Its dependence on commodity exports will benefit it in the coming period as factories in emerging markets roar back into life. In short, all bets are on the Aussie dollar remaining strong.