Australian dollar: Past the sweet spot

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Bloomberg is quoting US Treasury Secretary Tim Geithner this morning as saying that there is an increased:

“…threat of cascading default, bank runs and catastrophic risk” from the European crisis.

In the context of the Australian dollar, any recoveries you see this week that are unrelated to a resolution of this mess should be kept in perspective against this quote. I know that we have made the point about the Australian dollar’s so-called safe haven status is bunkum. But please just remember that as a non-core holding of everyone in the world – except about 22 million of us anyway – the Australian dollar is sold whenever markets retreat from risk and non-core assets. The past week is a case in point, with the AUD’s plunge from a high above 1.03 to a low of 0.9673 on Friday.

That level was close to my support line identified last week. I’ll get back to the charts later but first I want to quote from an article that I saw over the weekend in the UK Telegraph written by the former doyen of currency strategy Jim O’Neill, more latterly of Goldman Sachs Asset Management.

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Readers know I follow a consistent process when I am evaluating an asset or investment. The five drivers model that use to value the Australian dollar represents such a process and while I believe that in some people’s eyes the Australian dollar has been rerated, this rerating did not equal safe haven as recent trade has shown. O’Neill puts this nicely when he says:

This week, some more of the recognized winners of post-crisis markets suffered especially badly, notably gold. As I shall discuss below, the large correction in gold will force many to rethink the relevance of the safe haven concept, just as the weakness of the Swiss Franc since late August will have. In my judgment, all financial investments have a relevant valuation about which investors need to be aware. Any thoughts about persistent safe havens (other than perhaps cash under your mattress) are dangerous.

The point about this is not to bash those who thought the Australian dollar was a safe haven over the head per se but to make the point that currencies are complex beasts. They are made up of many different drivers and therefore require careful study not off the cuff cheerleading.

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On this O’neill says:

I am never entirely convinced about the idea of a persistent safe haven as it really depends on the economic and policy circumstances.

Correct – careful study, careful study.

Speaking of which, I’ll look at the charts in a sec but first lets run through the five drivers.

1. Global Growth and Commodities – The outlook for growth is weakening and weakening quickly. Europe has given itself 6 week’s to fix its troubles which to me seems a stupidly artificial construct to buy time but by inference it leaves a void for markets to do their own thing. So the outlook is darkening.

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Equally the CRB is off something like 12% so far this month and is in a clear down trend. Commodities are reviewing the outlook for growth and it is not positive

2. Domestic growth and interest rates – Australia is slowing as readers of MacroBusiness have known for some time. But increasingly the globe’s investors are waking up to this and are worrying about a Chinese slowdown and its impact on Australia. This is not a positive for the Australian dollar. There is 148 basis points worth of easing priced into the market over the next year and regardless of the RBA’s characterisation of this as “technical” in nature the reality is that markets think the Australian growth profile has softened.

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The contraction of the spread between Australian and US 2 year rates in and of itself suggests more downside for the Australian Dollar as you can see below:

Its never a one dimensional market but neither global and domestic growth are not supporting the Australian dollar

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3. Global Risk Appetitie/Aversion – the carnage across multiple markets suggests that position squaring is occurring all over global markets. That means risk is coming off the table as investors de-risk their portfolios. Bloomberg even ran a story this morning saying that the difference between Chinese Yuan rates in Hong Kong and on the mainland in Shanghai was at a record spread as investors liquidated positions. The Australian dollar does not do well in these conditions usually.

4. USD – The Prince has written some good stuff about this recently so I wont go over it again but the key point is that in times of panic some things are still consistent. One of them is that the USD does reasonably well. We have seen this again over recent weeks across both currency (developed and emerging) and commodity markets. Strength in the USD as the other side of the Australian dollar coin puts automatic downward pressure on the Australian dollar all other things being equal.

5. Technicals – there is a strong chance that the twin rejections of prices above 1.10 is now a double top and that the AUD will head back to 0.9200 and perhaps even 0.8000 on a longer term basis. There is much wood to chop, in terms of support on the way down, which we will talk about below, but this is the high level summary:

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On the hourly chart the AUD has been consolidating around/above the lows of Thursday and Friday night. This morning’s ill-fated stop run up to 0.9865 has faded quickly and the AUD now sits at 0.9767. The average true range per hour is up around 60 pips which is a warning to be careful as the currency is currently uncommonly volatile. If a break of 0.9670 occurs, that would take out the hourly low as well as the trend line on the dailies, see below, and suggest 0.9423:

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On the dailies, the Australian dollar is clearly now in a downtrend. Support comes in on the trendline identified last week around 0.9660/70 and then support comes in at 0.9608 and 0.9410/25. MACD indicators are overdone and my guess would be a consolidation period for a few days for markets to settle down. Resistance off the recent move above comes in at 0.9905 to 1.0067. Only a break of this later level would return the focus higher:

I look at this chart and all I see is downside on a weekly timeframe. The natural attraction point for the Australian dollar on this analysis is 0.9250, the 38.2% retracement of the move from the 2009 start of the rally (not the low of 2009). Just below here at 0.9228 is the 61.8% of the move from 0.8080 – 1.1080 for the 2010-11 rally. So this zone is important support.

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So it’s been a big week for the Australian dollar as the supports continue to get kicked out from underneath it. That does not mean it is doomed again this week, however. We know that volatility begets volatility but moves like last week and the spike in the average true ranges will keep traders and investors sidelined which often has the effect of curing the volatility. It is how volatility cleanses itself from the system.

But overall, it seems that the Australian dollar is biased lower, even if it rallies initially of this important support zone we have identified above, unless or until we see some concrete steps toward European banking and sovereign resolution and the global economic outlook picks up.