The Australian dollar has frustrated analysts and traders alike this year, stubbornly holding above 0.90 despite sharp falls in key commodity prices, an improving US economy, and heightened geopolitical risk. Indeed, many market players were left wondering if the $A was eschewing its long held relationship with commodity prices.

However, in mid-September, the pace shifted and there was some action under-foot. In the past two weeks, the $A has fallen from 0.94, to 7 month lows below 88 cents (see chart).

Source: Yahoo Finance

Why have currency investors suddenly decided to respond to deteriorating fundamentals?

In part, the fundamental story has weakened further. Further, significant falls in key commodity have made the commodity story difficult to ignore. In particular, iron ore – Australia’s largest export – has been stealing the limelight, with spot prices now below US$80 per tonne, the lowest since 2009 and down 41% year to date. The sharply weaker price reflects both softening demand from China and a flood of supply from key miners.

Meanwhile, the $US has finally gained some traction, recording broad-based gains in recent weeks. Remember currency markets are always a tale of two currencies, and without doubt part of the $A weakenss reflects USD strength.

The stronger $US has been underpinned by confirmation from the US Federal Reserve that it will wind up its historic quantitiatve easing program next month. This has provided financial markets with confidence that the economic recovery is now solid enough to absorb the tightening of this credit channel.

While Fed rate hikes remain a 2015 story, financial markets are increasingly confident that the ground is being laid. Meanwhile, US yields have finally started to rise, with the US 10-year convincingly clearing 2.5%.

In a world awash with liquidity, with Europe and Japan fighting our recession/deflationary cycles, the US looks like a solid investment bet. And heightened geopolitical risk is adding to the mix.

Global liquidity has supported the $A in the face of lower commodity prices.  The local currency has certainly benefitted its position as ‘high yield, low risk’ currency. However, sentiment has turned on the $A, and it is noteworthy that the $A has not just weakened against the US$ but also on key cross rates.

The most recent leg down in the local currency came on the back of comments from Reserve Bank of New Zealand Governor Wheeler, who warned “We expect a significant further depreciation of the exchange rate … past experience suggests that when the New Zealand dollar begins depreciating from an unjustified and unsustainable level, the ultimate adjustment can be large."

The RBA will be pleased to see the recent softening of the local currency – it is an appropriate economic response to weakening commodity prices and mining investment.

The final part of the puzzle, however, has nothing to do with economics or fundamentals. It is about markets – positioning and momentum. Recent downward momentum has finally vindicated those that held ‘short’ positions with clenched teeth as the currency did nothing. And now, any $A rally will be met by those few holding long positions wanting to offload them, and those needing to add to shorts. It’ll be hard for the $A to break back above 0.90 in this environment.

Where does the $A head now?

Lower is the answer, but how low and how quickly remains harder to predict. Economists have been looking for the $A to end this year at 0.87 and that now looks very reasonable.

Much depends on the USD and signals about the strength of the economic recovery and timing of eventual Fed rate hikes, as well as China and the impact on demand for Australia’s commodities. This year's low of 0.8660 looks likely to come in to play in coming weeks, and I see the local currency closing the year around 0.82-0.85.