Forex Investment and Currency Trading

USD approaching a top

Over the past month there has been biased towards USD strength as a disconnect formed between fixed interest and FX markets. This process has just about run its course. A Fed pause is now fully discounted into year’s end and a hike is priced in early next year. It’s diffi cult to see how the FOMC could provide yet further support to the USD. The risks are seen skewed substantially towards further Fed easing.

AUD - USD trend will still be important

On March 4 of this year people argued that the AUD was likely to correct from the 0.94/0.95 region back towards 0.90¢. This view reflected weaker domestic data, funding concerns and excessive bearishness on the USD. Since then the AUD has traded in a 0.90/0.9550 range, although we have been surprised by the resilience of the AUD to weaker than expected domestic data. As was the case then we think the USD will be very important for the A$ fortunes. Based on the above we clearly see the risk of a peak in the USD over coming weeks and hence are looking for further AUD strength from here.

To be sure, if concerns surrounding the US outlook re-emerge we are likely to see higher risk aversion/volatility return. Historically, elevated volatility has typically been a negative for the AUD, although this relationship has broken down over the recent period. The break down in the correlation is indicative of the subprime crisis/economic slowdown which has engulfed the US. Bad news is released, which sends volatility higher and the USD lower. Critically though the rest of the world has held up reasonably well despite the turmoil in US markets, particularly among Australia’s trading partners within the region. So if volatility kicks higher again this is not a hindrance to further AUD gains, assuming we don’t see significant spillovers into other parts of the world. We would also note that the iTraxx index for Australia is well down from record levels and pointing to further AUD gains from here.

If the view of the US is wrong and the Fed has indeed finished the tightening cycle then the USD has more upside from here. However, we suspect this would mostly be reflected against would be more bullish for AUD/USD.

Domestic data has cooled but terms of trade will be an offset

From the A$ perspective, the data has softened as the domestic economy has cooled. However, the data has by no means been uniformly weak and it’s hard to get too downbeat on the economic outlook when the terms of trade are forecast to rise by 23% this year. If realised this would be the largest increase in the terms of trade since the early 1950’s. The RBA noted in their policy statement today that the expected rise in terms of trade was much larger than that estimated a couple of months ago and would provide a stimulus to national income. This is one of the key reasons why market expects rates to remain at current levels until the end of 2009.

AUD - post float highs and beyond?

The terms of trade story has been in the market place for sometime now, so is it already reflected in the price? We would say to a certain extent yes but positioning is not at an extreme. CFTC positioning data indicates there is still plenty of upside scope for specs to build long AUD positions and this is with spot AUD trading around 80bps below a 24 year high reached a few weeks ago. Hence market positioning is not a hindrance to further AUD gains from here.

On the basis, the risks are for the AUD to push towards post float highs around the 0.9650¢ level and if this level gives way there will be little to stop a move to parity. Look to buy dips to the low 0.9300¢ region, with a stop around 0.9000¢.