Australian Dollar – Time for a pullback?

October 31, 2011

FOREX

I’m long jobs to do and short time today so I’ll have to keep this week’s Australian Dollar update brief. Key for me is that the back end of October has been the polar opposite of the early days of the month. Pessimistic crescendo followed by supreme optimism. The truth is neither emotion is either helpful or right which is why we have a consistent process we like to follow.

 So where are we now?

Last week’s high was 1.0750, just 15 pips shy of the target I identified at 1.0765 in last Monday’s piece. So that is good enough for me and I expect a deeper pullback than we have had o far. My initial target would be the 38.2% retracement level of the last week’s move at 1.0588 and probably even somewhere in the 1.0486-1.0537 region which are the 50% and  61.8% retracements respectively.

 Am I outright bearish? Not really, but the key thing for me is that my target was achieved, almost, but not exceeded and I strongly believe that markets have overdone things in the very short term and are ripe for a pullback while the concerns over the “stickability” of the plan and its broader impacts are worked through. Indeed the Italian bond auction which was 25bps higher in the 3’s than it was at the last auction in late September is a clue that contagion is not done with yet.

 So lets look at the stop lights

The past week was more positive than I thought it would be by a large margin and the latest is probably positive too based more on sentiment and a continuation of slightly better than expected recent US data but with so much hope now baked into the cake I have to expect that the next week will be one of consolidation and or pullback in equities and thus the Australian Dollar. Add to this the fact the RBA is either going to ease rates tomorrow, or signal a strong bias to do so in December (I’m betting on tomorrow) together with my expectation that risk appetite cant climb much from where it is short term and I’m biased lower on the week.

Indeed as the following charts suggest this is JUST a risk rally.

Now of course that is important – it is one of our 5 drivers – but the risk bounce has overwhelmed everything  else in a fundamental sense.

Take for example the Australian Dollar versus iron ore prices, we could use copper as FX Concepts did in a piece last week noting that,

When Aussie and copper are matched up there are very few divergences and when they occur they don’t last long. Copper is widely considered the commodity that most accurately predicts future economic growth and it turned sharply lower at the start of August, falling 35½% before recovering one-third of its losses during the past week. By way of contrast the Aussie has regained 60% of its losses and this has caused a wide divergence between the price of Copper and the AUD. This argues that either the Aussie should decline or copper should strengthen, or both.

What I would say to that and I think what the chart below shows is that the Australian Dollar is “outperforming” its own fundamental indicators as you can see in the chart above. The Aussie is the purple line heading up while Iron Ore prices are heading down.

Equally the Australian Dollar has outperformed the interest rate indicator in my model/process which is represented by the Australia/US 2 year spread – certainly both the currency and the spread moved up over the course of the month but the Australian Dollar looks to me to have accelerated a little too hard in this respect. Indeed as I mentioned some weeks ago the Aussie didn’t fall as far as this spread suggested either.

So what does it all mean?

Put simply the Australian Dollar is a hostage to risk and risk appetite. A reappraisal of the situation this week with regard to Europe will see some consolidation in my view and a likely pullback. But in the short term I’d expect it to be supported in the same manner as I expect the current ebullient markets to retrace but find support. Longer term though both market ebullience and the Australian Dollar will not be able to withstand a low growth future. Not at these levels anyway. I expect the 1.10/11 region to continue to hold medium term.

Cross posted with MacroBusiness

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

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