7 key reasons why the AUD is going higher

AUD/USD has rallied 14% since the January lows (9% on a trade-weighted basis), helped by a number of factors.

Anyone who aligns their trading bias to the underlying trend would see little reason to short the pair right now and the fundamental story clearly supports higher levels. The backdrop for AUD appreciation is about as good as it gets, so standing in the way of that is not something I am prepared to do. In fact, my preference is to stay long until proven wrong.

Specifically, the key supportive factors are:

  • China has been stimulating on a monetary and fiscal policy level. These levers are clearly working as reflected in China’s economics, and we should see Q2 growth closer to 7%.
  • With strong infrastructure spending and measures to promote the housing market, rebar and iron ore prices are pushing higher with steel mills ramping up inventory build.
  • Australian interest rate cut expectations have been falling, with the probability of a cut by the December meeting having fallen from 65% to 50%.
  • The RBA has not sounded concerned enough about the recent strength of the currency upsetting their inflation outlook, especially given terms of trade have improved, and as has domestic data. This is a green light for traders to keep buying.
  • The broad USD has fallen 7% since January and this has seen a wave of capital flow into emerging market (EM) funds. Emerging market equities and currencies have seen strong gains, assisted by the China stimulus. While Australia is not an EM as such, the AUD is seen as a cheaper proxy of emerging markets and therefore will do well when EM assets are seeing strong demand.
  • Volatility measures (such as the VIX) are at multi-month lows and this is spurring traders to reach out for higher yielding assets. If one adjusts Australian bond yields for the level of inflation (currently 1.7% year-on-year), investors can still get a ‘real’ positive yield. This is very attractive for global investors given the very low expected returns in other geographies.
  • The trend is higher, so many of the trend following hedge funds have been adding to long positions. As we can see on the daily chart of AUD/USD, a break of the multi-year trend resistance at $0.7810 would only accelerate the upside and the May 2015 high of $0.8165 seems a likely target.

It has to be taken into account that current pricing in the US interest markets shows traders’ sanguine on US rate hike expectations and the first rate hike is not fully priced into the market until May 2017. This has largely been influenced by the Federal Reserve detailing that they will allow inflation to overshoot their 2% target before raising rates, which could be a dangerous tactic.

Importantly, inflation expectations in the US are turning higher and perhaps markedly so if the S&P 500 and oil continue on their merry ascent. There will be a tipping point and when this occurs, traders will look much more favourably on the USD which could coincide with when much of the China stimulus wears off. This will be the time to short AUD/USD with much greater conviction, but for now the fundamentals suggest staying long. A move below the 15 April high of $0.7743 would alter my bullish stance somewhat and I would not take an outright negative stance until we saw the pair trade through the 7 April low of $0.7491.

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