Reaction to News – Not Always Obvious - The AUS Dollar

A recent headline this week on Bloomberg stated:

Australia Dollar Drops Most in 7 Weeks on Inflation: World's Biggest Mover Australia's dollar dropped, the biggest fluctuation of any currency today, after a government report showed inflation was slower than expected, reducing the chance of an interest-rate increase.

The headline and story seem at odds. The AUS dollar falls on better inflation numbers.
A simple model of exchange rate economics would have given a different answer. An exchange rate drop should be associated with higher inflation numbers if you follow a simple purchasing power parity story. A more complex exchange rate story is needed to rationalize this story.

The reporter states that the AUS dollar drop is driven by expectation that the central bank will now not raise rates. By not raising rates, the interest differential will not widen in Australia’s favor. This decline in the expected interest differential is what drove the decline. This explanation seems plausible, but will it have merit in other situations? Does the fact that a number of traders tell a reporter that this is the explanation make it valid? Did the report discard other explanation for the AUS dollar decline?

Too often reporters look for causality when it may not exist. In order to write a story, you need an explanation for what drives the market. But having a valid story for a given event is not enough for understanding the movements in exchange rates. The story must have predictive power in other situations. In this case, do expectations of central bank behavior dominate inflation news?

There are a number of ways to test these stories, but it is not as easy as running a simple regression. Expectations and reaction of monetary policy is a key driver in exchange rate dynamics which is often missed in the simple modeling. A simple regression using both including inflation and nominal interest rates can tell us the relative weights on these factors, but it does not include monetary policy expecations and may not explain the market behavior to given news events.

Conflicting but plausible exchange rates stories are what makes this asset class so difficult to understand. Prior to a news announcement there may be a number of alternative explanations which may seem valid. After the fact, one story will be proven to be true, but that does not mean that it is applicable for the next case. Be wary of what you read even if it seems plausible.