Firstly, global demand for Australia’s commodity exports will need to continue, sustaining these record-high terms of trade. While global growth is likely to remain supportive in general, inflationary pressures, especially in emerging markets, will probably compromise the sustainability of easy global monetary conditions. For this reason, the market will be watching the path that policy makers in Asia, and especially China, take during 2011. China has already begun tightening monetary conditions and we are likely to see additional policy measures to try and reign in the increasing inflationary conditions. Chinese consumer-price inflation printed 4.9 per cent in January 2010, and further gains are expected. Despite its moves to tighten monetary policy, its current central bank deposit rate is only 3 per cent, which implies real interest rates are still -2 per cent.

Predictions about China’s economic growth are an integral part of forecasting the strength of the AUD. China is now Australia’s largest merchandise export partner, receiving 23.1 per cent of our total exports. Iron ore and coal make up two-thirds of the total value of exports. China is also an important source of foreign direct investment into Australia, investing $9.1 billion in 2009. Leading indicators do show at least some sign of moderation and have tended to correlate with the AUD/USD relationship broadly over time (see chart 4). The RBA is more advanced in its domestic tightening cycle than most of the central banks in developed economies. Since rates troughed at 3 per cent in 2009, the RBA has cumulatively hiked by 1.75 per cent, and the market currently expects approximately 0.5 per cent in additional tightening. In our view, the impetus from widening interest rate differentials and the AUD are probably close to their peak levels in our view (see chart 5).

The AUD/USD has been closely aligned to movements in short-term interest rates over the last year, with a weekly correlation of 0.57. Should global yields normalise further, this would reinforce the case for a correction in the AUD/USD rate. The path of the AUD is unlikely to be straightforward in 2011. Given this uncertainty, it is difficult to advocate an Australian investor buying foreign assets fully unhedged. There are obvious headwinds and risks to the AUD strength and the global outlook, but there are still many important supportive factors for the AUD. Barring a sudden shock to global growth, Australia’s terms of trade will continue to hold firm for the foreseeable future as the impact of the Australian floods come through.