The economic outlook continues to improve for Australia. Most recently, both the government and the Central Bank released five-year growth forecasts, both of which show a modest recovery in 2010. “By 2011-12, the commodity-rich economy will again be firing on all cylinders with growth of 4.5%, well above the long-term growth rate of around 3%.”

This positive development coincided with the release of similarly upbeat economic data: “Retail sales surged 2.2 percent in March from the previous month, four times as much as economists forecast. Home-loan approvals jumped 4.9 percent, the sixth consecutive gain.” Meanwhile, unemployment shrank for the first time in months, and consumer confidence is once again rising. While the economy is forecast to shrink by .75% in the current fiscal year, this compares favorably with other industrialized countries.

The sudden turnaround can be attributed to a couple factors. First of all, the pickup in China’s economy is stimulating demand for natural resources, which had been slack for the last year. If not for simultaneously falling commodity prices, Australia might have even achieved positive economic growth for the year.

The government’s stimulus plan and spending initiatives have also played a role, although the extent cannot be measured accurately for a few months. “The government claims that measures in its budget will inject a further A$8.8 billion into the economy in 2009-10, adding to around A$50 billion in fiscal measures already announced since October 2008.”

The outlook for the Australian Dollar, meanwhile, is not so rosy. The 425 basis points in cumulative rate cuts that the Royal Bank of Australia (RBA) effected over the last year have lowered the interest rate differential with other industrialized countries. While the RBA has indicated that it will pause before cutting rates further, interest rate futures reflect the expectation that rates will be lower twelve months from now. “Economists say the RBA is open to cutting interest rates again if consumer and business confidence appear threatened, but for now it is content to let monetary and fiscal stimulus measures take hold.”

To be sure, the uptick in risk tolerance has been good for the Australian Dollar, igniting a 25% rise since March. The currency now stands at a 7-month high against the US Dollar. But the increasingly modest differential is now causing some analysts to question whether it is a reasonable risk to take, especially against the backdrop of volatility and a high correlation with global stock prices. “What’s the point of picking up a 3 percent interest-rate differential by being long Aussie and short Japan in a world where the exchange rate can move by that much in two days?” Asks One analyst rhetorically.

This same analyst is actually recommending investors to use the Australian Dollar as a funding currency, and go long on higher-yielding currencies, such as the Brazilian Real. This particular trade would have netted a respectable 5.9% return in 2009. How quickly the roles have reversed!

Against each other, the New Zealand Kiwi and Australian Dollar have traded in a pretty tight range for the last year (except for a “blip” in the fall of 2008). This makes sense, as both currencies rise and fall in accordance with exports and interest rates.

Against other currencies, meanwhile, both have torn upwards in the last couple months. Despite steep interest rate cuts, both currencies have maintained their interest rate advantages against other industrialized currencies. This has not gone unnoticed, and the return of the carry trade has been kind. “The current improvement in sentiment is providing an underpinning of support and while that remains the case - and that may be until midyear - the New Zealand dollar is going to remain well-supported,” said one economist.

The correlation between the New Zealand Kiwi, specifically, with the US stock market has become remarkably cut-and-dried of late, which you can see from the chart below. For carry traders, therefore, it probably makes more sense to follow stock market commentary than to track New Zealand economic data. The same economist, for example, warned “that the equities rally, which has seen the broad U.S. Standard & Poor’s 500 index climb 36% from its March low after rising another 3.4% Monday to its highest since Jan. 8, may be dissipating.”

Besides, given the deteriorating economics in both countries, lower interest rates are probably inevitable: “We think this case for further cuts will be made in the second half of this year…we think it will be very difficult, no matter what the global economy is doing, for the RBA to ignore rapidly rising unemployment,” offered one analyst who predicted that rates would be cut to a “trough of 2%.” In such a scenario, the interest rate spread would still remain healthy, but perhaps not enough to offset the additional risk.

Australian home prices are falling at a rapid clip, the labor market is sagging. In New Zealand, meanwhile, a decline in sentiment and consumer spending has corresponded with a 1% contraction in GDP in the quarter ended March 31. Tourism is down, although net exports are increasing. The current account deficit continues to expand, but this is mostly a product of an investment balance - perhaps related to the carry trade.

For now, forex traders remain optimistic, albeit slightly less so than before: “The difference in the number of wagers by hedge funds and other large speculators on an advance in the Australian dollar compared with those on a drop — so-called net longs — was 16,692 on April 28, compared with net longs of 17,250 a week earlier.”

When two weeks ago the Royal Bank of Australia (RBA) cut interest rates, one would have expected the Australian Dollar to suffer proportionately. Instead, the currency continued its steady upward rise, and touched a six-month high, before falling back slightly. One surprised analyst lamented, “These types of inconsistencies can make trading forex difficult or down right frustrating at times.”

The interest rate cut marked the sixth since September, since which point the RBA has trimmed its benchmark lending rate by 425 basis points, leaving it at 3%. [See chart below courtesy of "The Fundamental Analyst."] Traders have reacted to the successive declines in yield and simultaneous pickup in risk aversion by unwinding carry trades, many of which had been long the Australian Dollar. The massive sell-off that ensued left the Aussie a long way below the level of parity with the USD, which only last year many analysts had viewed as inevitable.

The most recent rate cut, in contrast, was greeted positively by traders, perhaps because they were expecting a larger (50 basis point) rate cut, but more likely because their priorities had changed. A pickup in risk aversion in recent weeks has definitely reinvigorated interest in comparatively risky currencies such as the Australian Dollar. Overall, the markets remain risk-averse, and investors are increasingly making bets in accordance with economic fundamentals, rather than yield levels. ” ‘The focus will remain on the global backdrop…Risk appetite is still fragile and the market is increasingly realizing that the recent recovery was excessive.’ ”

In the case of the Australian Dollar, traders were heartened by the RBA’s decision to lower interest rates to a 49-year low since it reflected the Bank’s commitment to dealing with the economic crisis. But at this point, the Australian economy is still in poor shape. “Prime Minister Kevin Rudd said yesterday for the first time that a recession in Australia is inevitable amid a slump in global growth that is eroding demand for natural resources from the world’s biggest shipper of coal and iron ore.”

Meanwhile, “The global economic downturn has pushed Australia’s economy into its first recession since 1991, Reserve Bank of Australia Governor Glen Stevens said.” According to the minutes from the RBA’s last meeting, “Conditions in the labor market continued to soften” and “Further falls in employment and rises in unemployment were expected.” These observations should be viewed in the context of a 5.7% unemployment rate.

The near-term prognosis for the Australian economy remains quite poor, regardless of whether a recovery materializes in 2010, as forecast by economists. Accordingly, analysts expect the RBA to lower its benchmark interest rate further, probably to 2.25% or 2.5%; there is a “bias toward further modest rate cuts, although we continue to think that the RBA may well pause for a few months to assess the impact of the current round of fiscal stimulus,” offered one forecaster.

Given the lull in market activity, some commentators have turned to technical analysis. “Westpac Currency strategist Robert Rennie said their own risk measurement models are clearly flagging a bumpy period ahead for high yielding currencies. ‘Our proprietary models are…clearly telling us to watch risk sentiment and data much more closely than we have over the past six weeks.’ ” In short, traders should not become complacent as result of the Aussie’s recent rally, and should continue to monitor economic data for signs of progress and/or hiccups on the road to recovery.

The Swiss Franc is in the same boat as the US Dollar and Japanese Yen, benefiting from an increase in risk aversion and an unwinding of carry trade positions. In other words, the currency rising on the back of the sound monetary policy of the National Bank of Switzerland, with its low rate of inflation and proportionately low interest rate. Despite the fact that the Swiss economy is poised to contract in 2009, its economy is in better shape than its rivals, and its current account balance is still in surplus. As a result, the consensus among analysts is that investors will continue to flock to the Franc, as Switzerland is sill perceived as a relatively low-risk place to invest. Especially compared to the Euro, which has risen against the Dollar of late, the Swiss Franc remains undervalued. Bloomberg News reports:

Investors are drawn to the franc in times of international tension and economic upheaval because of the country’s history of neutrality and political stability.

Read More: There's Nothing Swiss Can Do to Stop Franc's Rise

While the Australian Dollar and New Zealand Kiwi technically started 2009 in the black, most analysts believe that both currencies will continue their record declines that began in 2008. All economic indicators continue to point downward, due to the adverse conditions created by the worldwide recession. The economies of Australia and New Zealand are extremely dependent on exports of raw materials and dairy products, respectively. Unfortunately, due to a contraction in demand and a decline in speculation, the prices for both types of commodities appears unlikely to erase even a fraction of the losses suffered last year. The death blow into the heart of both currencies will likely be delivered by their respective Central Banks, which are expected to make additional interest rate cuts. This will further erode the rate differential with the US/Japan, that previously signaled the currencies as attractive investments. Bloomberg News reports:

The average forecast is for the currency [AUD] to reach a low of 62 cents in the first quarter before recovering to 66 cents by the end of 2009. New Zealand’s dollar…will bottom at 52 U.S. cents in the second quarter and recover to 55 cents by the end of the year…

Read More: Australian, New Zealand Dollars Complete Worst Year on Record

On the basis of technical factors, the Australian Dollar had halted its precipitous decline against most major currencies. As a result of an unbelievable 100 basis point interest rate cut, however, the currency has resumed its fall. That the rally was short-lived is not a mystery. The yield advantage enjoyed by Australia over the last few years has almost completely evaporated. Combined with lackluster Australian equity performance and tanking commodity prices, foreign investors have little reason to maintain capital in Australian holdings. On the plus side, the rate cut showed investors how serious Australian economic policy-makers are in dealing with the credit crisis. Unfortunately, diligence doesn't always translate into efficacy.

Read More: Dollar back under pressure

The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels. Now that investors are chasing stability/capital preservation instead of yield, however, the currency has seriously fallen out of favor. The Australian reports:

Equity markets would continue to drive currency markets, while being influenced by the ongoing financial crisis. "These are unprecedented times in volatility for the Australian dollar and currencies," said [one analyst].

Read More: Dollar crashes to five-year low

Over the last two months, the South African Rand has plummeted, losing nearly 20% of its value against the US Dollar en route to a five-year low. It seems the currency has become the latest victim of the credit crisis and the resulting widespread risk aversion. The sudden exodus away from the carry trade, for example, has affected the Rand disproportionately, as many foreign investors had come to South Africa over the last few years to take advantage of the country’s 12% interest rate. Now, the country is facing a horrible crisis, and is worrying about its ability to finance its current account deficit, which already exceeds 7% of GDP. Accordingly, analysts predict the Rand will continue to drop. Bloomberg News reports:

"The portfolio flows we have seen over the past couple of years are going to dry up and we will not be able to fund the deficit with the portfolio flows." The rand may slide to 9.20 rand by the end of the year…

Read More: South African Rand Declines to Six-Year Low on Credit Turmoil

It would seem as if the world is conspiring against the Australian Dollar. In the last couple months, the currency has plummeted nearly 20% from the 25-year high it had reached against the US Dollar. A combination of global economic weakness, falling commodity prices, and a trend towards risk aversion have turned the tables in favor of currencies perceived as more stable in times of crisis. To add insult to injury, the Central Bank of Australia decided to cut its benchmark lending rate, narrowing the interest rate differential that had been partially responsible for the Australian Dollar’s multi-year appreciation. Bloomberg News reports:

"In the near term, the question will be do we hold here or go down a bit more on interest rates?” said [Central bank Governor Glenn] Stevens.

Read More: Australia’s Consumer Sentiment Gains for Second Month

I won’t lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it’s easy to forget that there are unique circumstances that weigh separately on them.

Over the next 12 months, both countries’ Central Banks are expected to significantly lower their benchmark interest rates as a result of slowing economic growth. However, as New Zealand does not have a large stock of natural resources to depend on in times of economic turmoil, it is projected to lower rates quite sharply, compared to Australia. Accordingly, the Australian Dollar may represent a buying opportunity against the Kiwi in the near-term. Bloomberg News reports:

New Zealand’s dollar is likely to fall 8.7 percent to NZ$1.33 versus Australia’s by year-end as the nation’s economic slowdown accelerates, boosting prospects the RBNZ will lower borrowing costs…according to RBC Capital Markets.

Read More: Buy Australian Dollar Calls Versus New Zealand Dollar, RBC Says

Is the "parity party" on or off? That is the question on the minds of currency traders following the Australian Dollar. Last week, analysts indicated that the party had been postponed, if not cancelled entirely. This week, there are signs that perhaps some of the bearishness surrounding the AUD is overblown. To be sure, the Australian economy is slowing, and the Central Bank will almost certainly lower interest rates. At the same time, some analysts believe that commodity prices have fallen too far, and will recover in time, as the long-term fundamentals that have underlied their rise still remain in place. Besides, the currency’s losing streak is already the worst since 1980, which suggests investors have gone too far. The most likely scenario is a bumpy 2008 for the currency, followed by a strong 2009. News.com.au reports:

[One analyst] said a recovery in global commodity prices could give the currency a much-needed bounce over the next few months. Citigroup has also forecast that the global markets have turned "too bearish" on commodity prices.

Read More: Aussie dollar falls back to Earth

The parallels between the Australian Dollar and the Canadian Dollar are remarkable! Both currencies are backed by economies highly dependent on natural resources. Both countries’ Central Banks are considering rate cuts in response to slowing growth. Finally, both currencies have slipped well below parity with the US Dollar. Unlike the Canadian Loonie, the AUD had never quite breached the mythical 1:1 level with the USD. Furthermore, given the deteriorating economic picture in Australia, parity is off the table for a long time.

Demand for Australia’s vast natural resources had begun to taper in response to rising prices, and now that prices have softened, exports are off even more. The Central Bank of Australia is indicating that it considers this drop in demand more of a threat than rising inflation. Accordingly, it will attempt to cushion the blow by lowering rates, perhaps as soon as next month. The Australian Dollar’s status as a beneficiary of the carry trade- because of the lofty 7.25% benchmark interest rate- may soon come to an end. Bloomberg News reports:

Investors have increased bets the central bank will cut borrowing costs. [It] will lower the benchmark rate by 91 basis points, or 0.91 percentage point, in the next 12 months, showed [one index].

Read More: Australia Signals First Rate Reduction in Seven Years

By one measure, the US Dollar has lost 33.8% of its value under President George Bush, its worst performance by far under any one administration. The burgeoning twin deficits, lackluster economic performance, as well as the current environment of stagflation have all contributed to a dramatic and unprecedented loss of confidence in the Dollar. While investors are understandably optimistic about the prospect of a new President, come January, they are ambivalent as to whether it is Barack Obama or instead John McCain that is ultimately elected. Since the Dollar seems to have bottomed out anyway, the new President stands to preside over a recovery of the Dollar. Reuters reports:

"We look at the dollar as a brand and any change from Bush will help benefit the dollar."

Read More: Forex investors see new president helping dollar

After a brief hiatus, the Australian Dollar has resumed its upward march against the Dollar; its next milestone will be a 25-year high against the Greenback. Of course, its continued strength is due to a combination of high domestic interest rates and high commodity prices. In fact, its performance seems to mirror the price of gold, which is no coincidence since gold may be Australia’s most valuable export. In addition, gold has value as a monetary instrument, which means an appreciation in gold can give the Australian Dollar a double-boost by lifting it while simultaneously punishing the US Dollar. With regard its domestic monetary policy, Australian inflation recently passed the 4% mark, which means interest rates (already at 7.25%) are likely to stay high for a while. The countdown to parity continues, reports Bloomberg News:

The local dollar rose to its highest since 2000 against the New Zealand currency before an inflation report tomorrow that may support the case for the Reserve Bank of Australia keeping interest rates at a 12-year high.

Read More: Australian Dollar Trades Near 25-Year High as Commodities Rally

Only last year, the idea that the Australian Dollar would ever reach parity with the USD was laughable. Then, earlier this year, it became plausible. Now, according to an informal poll of analysts, it is not only possible, but likely. AUD bulls should look no further than the rapid surge in commodity prices, which may boost the total value of Australian exports by 20%, including a 30% rise in its commodity exports. In short, the Australian economy has boomed, and inflation is slowly creeping up. The consensus among economists is that the Royal Bank of Australia will leave its benchmark lending rate unchanged at 7.25% for the duration of the year. At the very least, it won’t lower rates, which is all analysts need to believe in order to get behind its currency. Bloomberg News reports:

"There could be some parity parties going on,” said a currency strategist in Sydney at RBC, a unit of Canada’s largest bank. "The RBA…[has] given a green light for the market to push the currency higher."

Read More: Australian Dollar to Equal U.S. Dollar, Analysts Say