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Inside the Aussie dollar's global domination

Since the start of the year, the Australian dollar has risen strongly against every major currency, leading many economists to speculate on whether it is overvalued.

Currency traders say investment flows, as much as if not more than economic fundamentals, are behind the Aussie's stellar rise.

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Aussie dollar surges past US77c

The Australian dollar clears the US77c mark, its highest since the US election. Vision courtesy: ABC News 24.

On Friday afternoon, the Australian dollar was up 6.7 per cent against the US dollar from its position at the start of the year. Against the Euro, it's up 5.0 per cent; against the Japanese yen, it's 3.6 per cent higher.

On a range of metrics, many warn the dollar's current valuation is unsustainable. 

"The Aussie to me looks overvalued at 77¢," said Guy Bruten, the senior Asia-Pacific economist at investment manager AB Global at a media briefing.

"Our view is that the commodity impact is likely to fade and that, by the time we get to the tail end of this year, the RBA is more likely to be cutting rates than tightening," Mr Bruten said. "[This] puts downward pressure on the Aussie. Could we return to the low 70s? I think that's a reasonable expectation."

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Expectations of the Federal Reserve raising interest rates, which Fed governor Janet Yellen has hinted may happen sooner rather than later, suggest the differential between Australian and US interest rates may increase, giving investors more bang for their buck to dump Australian assets and flow into the US. 

On a purchasing power parity perspective, the Australian dollar is certainly overvalued, said Marcus Tuck, the head of equities at fund manager Mason Stevens. Purchasing power parity measures assume that a set basket of goods should cost the same when converted to a common currency from local prices. 

"Based on the latest CPI-based PPPs, the Australian dollar is about 8 per cent overvalued against the US dollar. Only the NZ dollar and the Swiss franc are currently more overvalued against the US dollar," Mr Tuck said.

Commodity prices, particularly iron ore, have risen strongly this year. The Australian dollar has historically been closely tied to the price of iron, the country's largest export. For Stephen Innes, the Singapore-based senior trader at OANDA, this is the major driver of the Australian dollar. "Commodity prices talk louder than the words of any central banker," he said.  

But Greg McKenna, chief market strategist at AxiTrader, said it was broader than that. He said global investors take positions in the Australian dollar when they want to take a bet on global growth.

"The Aussie dollar is the global investors' favourite punt," Mr McKenna said. "It's a way for global bond investors and global currency managers to reflect their view on where the global economy is going. The global backdrop – rather than anything Australia-specific – is the key driver."

Most trading on currencies takes place in private, over-the-counter transactions, making it hard to see for sure who is driving the appreciation of a currency. One measure that does give analysts an insight is the International Monetary Market in Chicago, which once a week publishes a gauge of speculative activity on the Australian currency. In the first few weeks of this year, traders and investors have been going long – betting a security will rise in price – on the Australian dollar.

The Australian currency is one of the most liquid in the world, and the second most-traded in Asia after Japan's, said NAB global co-head of foreign exchange strategy Ray Atrill. Japan's currency is more driven by domestic factors, leaving the Australian currency as a key way of getting easy exposure to the emerging markets of Asia.

"All emerging currencies in Asia tend to move in lockstep with China, and the Aussie is a highly liquid currency whose fortunes are very much tied to China," Mr Atrill said. "It's a liquid proxy for betting on positive things happening."