The AUD/USD currency pair, which expresses the value of the Australian dollar in terms of the U.S. dollar, continues to rise as global risk sentiment remains largely positive. However, there are evident risks to this run which we should consider.

One of the most transparent ways of measuring risk sentiment is by keeping track of global equity performance. U.S. equities are one of the most popular equity markets in the world, and so they present a useful indicator. One of the starkest correlations in recent times is the strong, positive correlation between S&P 500 futures prices and AUD/USD. The chart below illustrates AUD/USD price action using daily candlesticks, while the colored line represents S&P 500 futures.

AUD/USD vs. S&P 500 Futures(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)

The Australian dollar is still considered a commodity currency, due to the importance of certain commodity markets and exports of commodities to the Australian economy, including its direct exposure to China and other developing countries (especially in Asia). This is why the Australian dollar tends to rally versus the U.S. dollar (or USD) and Japanese yen (or JPY) as risk sentiment improves globally.

However, the strength of the correlation between AUD and the S&P 500 is beginning to look comical; it indicates that markets are re-pricing currencies such as AUD predominantly in line with equity flows rather than in accordance with economic data (vis-à-vis the economies of the United States and Australia, specifically). In the chart below, which stretches from around 2011 to present, the bottom panel shows the rolling 20-day correlation coefficient between AUD/USD and S&P 500 futures prices.

Correlation between AUD/USD and S&P 500 Futures

The bottom panel reveals the strength of the correlation recently. The chart above shows that the correlation was similarly strong throughout much of 2011 (and a good portion of both 2010 and 2012). The chart below provides a look into the period from 2011 through 2014. I have also noted certain points on this graph below which I will comment on further, including the drop in equities in 2011 which serves as a reasonable analog for the recent equity market decline in 2020 for our purposes.

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AUD/USD vs. S&P 500

Note that at the first point, equities (the colored line) sold off, as did AUD/USD. During and immediately subsequent to this period, the correlation between these two instruments (AUD/USD and S&P 500 futures) strengthened. Both bottomed practically in unison at the second point on our graph, while both staged a ‘recovery rally’ through to the third point.

We are currently at this third point in July 2020. No one can say with confidence whether the market will sell off again in the near term, as the analog of 2011 and 2012 might begin to suggest; in fact, in 2012, you will notice that equities exceeded their levels in the prior year (i.e., prior to the correction in 2011). We might need to see all-time highs in 2020 before we see another significant correction.

Yet in any case, the graph above becomes interesting from the fourth point through to the fifth point; this is where the correlation breaks down, and AUD/USD begins to fall in spite of a strong equity market.

This is not terribly surprising, since equities represent businesses which produce earnings, which in turn provide a yield (whether only an earnings yield, or a dividend yield too). When an asset produces a yield, the value of its yield (i.e., the asset’s market price) is always affected by underlying interest rates. As interest rates have fallen substantially over time (the Federal Reserve’s short-term target is now at the zero lower bound, at 0.00-0.25%), valuations have steadily risen, especially as corporate earnings have at least historically grown fairly consistently (prior to the COVID-19 pandemic).

Currencies rarely move in a unidirectional fashion, because they more closely represent macroeconomic ratios rather than assets. Currencies do produce yields, and therefore interest rate differentials do matter. However, with the Reserve Bank of Australia’s short-term rate of just 0.25%, the differential between U.S. and Australian funding rates are extremely tight. There is practically no carry trade appeal for AUD/USD, and as such we should begin to see the pair now trade more closely in accordance with macroeconomic performance differentials rather than in accordance with just risk sentiment.

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The timing of the breaking of this correlation is, well, difficult to time. Yet as the 2011/12 analog might suggest, the chances are now higher given that AUD/USD has returned to its “pre-COVID” trading range midpoint. Notice that AUD strengthened during the first quarter of 2012, alongside equities, but essentially peaked around the area that represented its “pre-crash” trading range. This is where AUD is at present; in alignment with its late-2019 and early-2020. It is also precisely now that AUD is evidently not as bullish (see chart below).

AUD/USD vs. S&P 500 Futures

AUD/USD has successfully returned to its previous trading range, and even sits above the 0.6850 level which represents the midpoint of its previous range. The price action could be interpreted as being bullish, but we should not ignore history, nor the recent sell-off in AUD as the currency was able to breach the top of its previous trading range (above the 0.70 handle).

Despite the strength of the AUD-equity correlation in recent times, we should begin to consider the possibility of this correlation breaking down. That means that we should consider the possibility of either AUD strengthening as equities fall, or equities continuing to strengthen as AUD falls (or as AUD remains range-bound at current levels). Given the uncertainty surrounding the global economy at present, we might want to view further AUD strength with skepticism.

Australia is a net exporter of mineral fuels (compare approximately $90 billion in exports of mineral fuels including oil, versus about $30 billion in imports), while the country also exports significant amounts of ores, slag and ash (other commodities, which together with mineral fuels represent about 60% of the country’s total exports). Should the oil markets remain stable, and counting on a so-called V-shaped economic recovery, AUD might be able to hold up against USD.

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Yet in spite of recent upside, AUD/USD remains in a long-term bear market. The chart below compares the 20-week moving average (in green) with the the 50-week moving average (in red); the former remains under the latter. (The chart uses weekly candlesticks.)

AUD/USD Moving Averages

Arguably, Australia is less likely to raise its interest rates before the United States, as higher interest rates usually strengthen a country’s currency (due to the attractiveness of the spread, from a carry-trade perspective). Just as Australia will be seeking a strong domestic export market to enable it to recover as expediently as possible, it is unlikely that the Reserve Bank of Australia will want to see AUD strengthen materially in FX markets for the foreseeable future.

With U.S. rates more likely to rise prior to Australian rates, we should once again consider the possibility that AUD’s recent run may be coming to a close. While further upside may be in store, it would seem that any further upside may be limited, and that the currency may now start to begin to detach itself from risk sentiment as a primary driver.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.