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The Aussie dollar has been garnering a lot of attention recently after rejecting 1.06 in early August. Since then it has fallen sharply versus the dollar even as other currency pairs like the euro have managed to perform well against the greenback. Since August AUDUSD is down nearly 3%, compare this with EURUSD, which has risen more than 4% over the same time period.

So why has the Aussie been in the doldrums, and why has the currency, sometimes called a proxy for risk, performed so badly compared to other risky assets like stocks in recent weeks? The chart below shows the relative performance of AUDUSD (blue line) commodities (red line) and the S&P 500 (green line).These asset classes had a fairly close positive relationship for most of this year, and they all moved in the same direction. However, during the summer as the S&P 500 managed to rally the Aussie fell along with commodities.

There are a couple of reasons for this: the US economy has managed to eek out some growth so far this year, which has helped boost corporate profits for US companies. In contrast China - the world's most important consumer of commodities - has slowed down sharply, which has weighed on commodities and commodity producers like Australia.

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Source: Forex.com and Bloomberg

So what drives the Aussie and where could it go to next?

The chart above only tells one part of the Aussie story. There are three drivers of the Aussie dollar: 1, commodity prices, 2, domestic interest rates and 3, overall market risk.

Australia is a major producer of iron ore, and as Chinese demand for this mineral has dried up (it is a major component of steel) its price has plunged. As you can see the price of iron ore and AUDUSD don't have a particularly strong correlation although they tend to move in the same direction at times. The Aussie has fallen, but not nearly as much as the price of iron ore. However, if the commodity price picks up it could have a mildly positive impact on the Aussie going forward.

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Source: Forex.com and Bloomberg

The Aussie and interest rates

The Aussie has a close relationship with domestic interest rates, as you can see in the chart below. Australia has the highest interest rates in the G10 as its economy has held up better than elsewhere However, when the RBA starting cutting rates earlier this year the falling rate differential with the US started to take its toll on the Aussie. After cutting rates from 4.75% in April to 3.5% today the RBA seems to be in wait-and-see mode. The chart below shows AUDUSD (blue line) and Australian rate expectations for Q1 2013. Rate expectations had started to pick up a little, which mirrored a rise in the Aussie between May and July when it reached 1.06. However, as rate expectations stopped moving higher and stalled in recent weeks this has added to the downward pressure on the Aussie. Overall, RBA policy action will be determined by what happens in China, the mining boom and overall market risk. Hence, it's hard to see rates rising anytime soon as long as these risks remain on the horizon. This could limit Aussie gains going forward.

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Source: Forex.com and Bloomberg

What this means for the AUDUSD:

The Aussie is being hit by three fronts: 1, overall market uncertainty and risk aversion, 2, China's economic slowdown and the impact on commodity demand and 3, domestic interest rates and the narrowing of Australia's interest rate differential.

Thus, we can't see it sustaining a break above 1.06 - the recent highs - anytime soon. The break below 1.0325 on Thursday - the 200-day moving average and a major support zone - is important as it suggests the Aussie bears are gaining in confidence. This pair may rally on the back of a dovish Bernanke speech on Friday, but without China picking up the rally might not be sustainable. From a fundamental perspective AUDUSD looks vulnerable. 1.0280 - the top of the daily Ichimiku cloud is a key support zone. Below this level opens the way to re-test 1.0150 then 1.0035 in the medium-term.

AUDUSD: Daily Ichimoku cloud

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Source: Forex.com

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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