Australian dollar is headed lower

See the latest Australian dollar analysis here:

Australian dollar ugly in the Euro mirror

What’s your view on equities, the S&P 500 or the bourses of Europe? The reason I ask you this question is because if you can riddle me that then you know where the Australian dollar is going to head in the next week or so.

As the Prince showed earlier today in C0TD, whether its commodities, or in this case the Australian dollar, for many markets it’s just a punt on what you think the equity market is doing.

Take a look at this correlation chart from my Bloomberg terminal this morning, focusing on the third column in, and you see that over the past 3 months the Australian dollar’s daily correlation with the S&P 500 (SPX) is 0.861, with the EUR it is 0.80 and with European Financial Stocks and the European Itraxx CDS index it is 0.79. It has a strong negative correlation with the CBOE Vix volatility index:

Clearly no surprises there, but the key message is that the Australian dollar is not trading on its own fundamentals, or if it is trading on its own fundamentals and perceptions of same, then everything is being influenced by Europe and the ebb and flow of sentiment about its impact on markets near term.

Indeed check out the chart below:

What you see is the Major commodity currencies (AUD, CAD, NOK, BRL and NZD) daily since the beginning of October versus the CRB and the S&P 500. These have been indexed to 100 as at the 3rd of October this year and while you can see the correlation in terms of “levels” or percentage moves is not as strong as the directional correlation we outlined above, it is clear that there is but one song in markets at the moment and it is the Siren Song. The only question is who is Odysseus – perhaps Nicholas Sarkozy, given last week’s clearly traumatic events.

So what does it all mean?

It means that for all the 5 drivers and their importance for the Australian dollar, it is really just investor sentiment, fear and courage, that is driving it at the moment.

But that does not mean the 5 drivers are irrelevant and I think that they all are biasing the Aussie lower over the months ahead.

1. Global Growth is looking weaker by the day – particulalry in Europe but as the RBA so eloquenty highlighted with both its rate cut last week and its SoMP last Friday the risks are skewed to the downside. Heavily so, I would argue.

Equally the wekaness in our bulk commodities and the outlook for same flows from the reduced ebullience about the developed and developing world’s growth profile. This is also a negative for the Australian dollar.

2. Interest rate differentials – I personally think that cash rates in Australia are going to 3.5% next year. Not quite as aggressive as the market is currently forecasting but substantially lower all the same from current levels. This will drag the 2 year yield down even further than it is at the present and further compress the spread to the US and other nations. Sure we’ll still be relatively high by developed world standards and so all support wont be kicked out but this is certainly a negative environment.

3. The USD is moving up and down with risk as well – safe haven, no need for safe haven and so on. I doubt, however, that it will be as fundamentally weak as it was earlier this year because at least on a relative basis the US is outgrowing Europe and many other developed countries. So there will be residual support in that sense. This is not an overwhelming weight on Australia but because I think it is all going to be about economics in the months ahead I would expect the USD to improve further as risk appetite goes off in some form.

4. Technicals are currently rangebound. The Aussie is constrained in a 1.0750/65 – 1.0230/40 range with the bottom end of same giving support last week on a daily basis. I personally think that this support will break eventually but there is much wood to chop and support below that as well.

As you can see in the chart below the Australian dollar has not closed below the old uptrend support (1.0309 today) since it broke back up on October 24th. This to me would be the first signal of a deeper retracement but 1.0230/40 needs to give way on a daily close basis to really open up a move lower so I’m not going to get too bearish yet:

So, summing up, I think the Australian dollar, like all other assets classes and indeed my sleep patterns, are hostage to the European crisis. If you can tell me where this is headed then I can tell you where Aussie is going. But overall my bias is to sell rallies as they occur because I think the world is turning decidely unfriendly for the Australian dollar.

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  1. Personally your bias to the downside is to be lauded.
    What is the catalyst driving the AUD??
    Growth in the Demand for materials?
    What growth, how much? and how can we respond anyway with the infrastructure constraints we’re afflicted with?

  2. I am guessing the dollar will keep going up and down by a few cents for for the next few months. There will be a constant swing between markets fearing the reality of the situation and leaders raping and pillaging to kick the can down the road just a bit longer.

    Italy yields climbing above 7% (6.5% likely today). EFSF having trouble getting funded. European economic indicators heading further south. The US debt-committee gridlock enacting automatic cuts. All bearish.

    The ECB or IMF stepping in and selling out as a lender of last resort? The ECB printing? QE3? China helping out in return for anything they desire. Rumors of another plan for a plan to solve everything. Rainbows and unicorns. All bullish.

    The IMF thing worries me as it is essentially spreading the risk from just Europe to the rest of the world. If it gets used and later expanded, it means that the can will be booted forward by months, if not years without solving any of the underlying problems. Then one day, as global economic growth turns negative, countries will begin to default and plunge everyone into deep deficits.

    Am I overly bearish? I don’t think this is unlikely in the medium-term. Debt fueled growth is over yet it is the basis of all future forecasts.

  3. Thanks once again for your views DFM. I especially like your first paragraph as it summarises my views on the Aussie. I can’t make sense out of the AUD/USD chart, but the S&P 500 and EUR/USD are crystal clear, and likely headed lower in coming weeks. If that is what ends up happening in those markets, the AUD/USD should be dragged lower regardless of other factors.

  4. dumb_non_economist

    For some reason there isn’t a “Leave a Reply” tag available for Trading Day and Grilling Qantas posts.

  5. Thank you DFM for sharing these interesting & important observations. I like your last paragraph in particular. Personally I am expecting a black swan or two to land within the next month and take everything incl equities, AUD & PMs down but this is just a hunch without any official knowledge and is solely based on reading about banks, debt, currency debasement, US, Europe and BRICs, and trying very hard to understand what’s going on. I wouldn’t be surprised if the markets just rallied on even though it wouldn’t make any sense whatsoever.

  6. Who knows seems all fundamentals are out the door on the AUD right now. Maybe a crash in commidities, RBA cuts the hell out of rates, job market and real estate market crash would bring below parity. I think over the next 6 months it will be between 98 – 1.05 even as rates go down. Even at 3.5 thats still way higher than most western countries right now. Australia is being hyped up around the world as the lucky country, which if most investors did their homework would find the major risk involved here, and think that nothing can go wrong here. Probably 98% of it all depends on where China goes if they crash AUD will be killed if they stagnate AUD will stay up and down between the levels above.