The Australian dollar is at its highest for more than decade against the euro and at a multi-decade high against the pound. What does this tell us about the situation in Europe and the impact that this is likely to have on the Australian sharemarket?
Risk and uncertainty in the sharemarket is on the rise. How do we know this? One place in which we can see this unfolding is through the currency markets.
The euro is at an all-time low and you can see by the graph above which shows the EURAUD FX, that it has seen a dramatic fall against the Aussie dollar in the past year.
This demonstrates the uncertainty in the euro zone at the moment. Watch for a reversal in this trend to demonstrate that perhaps the tide has turned.
One of the best ways to get a handle on risk in the markets is examine the relationship between the Australian dollar versus the US dollar or Japanese yen.
When there is uncertainty, investors and traders tend to move towards safe havens. In the currency markets, the US dollar and Japanese yen are considered safe havens.
While this may seem strange with both Japan and the US experiencing weak economies, when it comes to currency trades, people tend to get back into these traditional safe haven currencies when things turn bad.
In contrast, the Australian dollar is seen as a risky currency despite our relatively strong economy. That's because our currency is seen as tied to the global demand from commodities.
People turn to currency trades partly due to the carry trade. This is when you buy a higher yielding currency such as the Aussie dollar and sell the lower yielding currencies such as the US dollar.
When things start looking bad, people try to unwind their carry trades and this results in buying back the US dollar and selling the Aussie dollar. So some of the perception around safe havens comes from the role of the US dollar and Japanese yen as a cheap funding currency in risky carry trades which are unwound when things start looking bad.
So we can easily see whether traders are tending towards risky assets such as the sharemarket or towards safe assets such as cash through the rise or fall of the Aussie dollar against the USD.
You can see in the chart below which shows AUD/USD in the last year that between March 2009 to October 2009, investors were comfortable to add risk. In the last few months, it's been a battle between the risk takers and the risk adverse. You can see risk taking being in fashion when the AUD is rising and the battle between risk takers and risk averse with Aussie dollar moving sideways over the last few months.
So while we don't have a fear index like the VIX (a volatility index used in the US) to measure volatility in the Australian market, we can refer to currency trading to see whether investors are generally becoming more risk takers (and hence moving back into shares) or risk averse and moving towards currency markets.
Happy trading!
Julia Lee Equities Analyst Bell Direct
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