AUD/USD Outlook: Will the Currency Rise to Parity?

The Australian dollar was one of the best performing currencies in the third quarter. Despite a sharp sell-off between the end of July and middle of August, the currency raced to an 18 year high against the US dollar on the last trading day of the quarter. It then went on to hit a 23 year high the following week, raising the question of whether the Australian dollar will be the next currency to be even with the US dollar.

The enviable gains in the Australian dollar crosses indicate that the currency’s strength is not due to US dollar weakness alone. Instead, much of the Australian dollar’s rally has been fueled by solid economic data and skyrocketing gold prices. However as the Aussie continues to rise, the strain that it puts on the economy will increase as well. Also, it remains to be seen whether the fallout from the subprime fiasco will leave any long term damage on the Australian economy.
[B]Tight Labor Fuels Strong Consumer Spending[/B]
With unemployment whittled down to a 33-year low of 4.3 percent, it is hardly surprising that retail sales in the month of August doubled expectations. Since the beginning of 2005, annual wage growth has measured over 3.9 percent. Recent income tax cuts and lower gasoline prices in August helped to spur increased spending at restaurants. The economy is now into its 16th consecutive year of expansion thanks to solid demand from Asia. With their coffers overflowing from export revenue and quickly growing consumer demand within its own boarders, Australian businesses have turned record breaking revenues into investments to keep up with growing demand. This has led to notable surge in capital expenditures and employment. From the most recent GDP breakdown, business investment rose 4.5 percent over the second quarter to add 0.7 percentage points to overall growth. The economy is doing well and consumers are spending, but businesses are starting to become worried that a potential interest rate hike and strength of the Australian dollar will make business conditions more difficult in the months to come. As a result, business confidence measured by the National Australia Bank has plummeted to an 8 month low. The foundation of the housing market is also starting to show its cracks. Residential building through the second quarter dropped 4.0 percent following a 1.1 percent contraction in the previous period. For a more up to date figure, home sales in August plunged 8.6 percent. If there is more evidence of a slowdown in the domestic economy, the Australian dollar’s impressive rise may come to an end.
[B]What Will the Reserve Bank of Australia Do?[/B]
In the meantime, speculation that the Reserve Bank of Australia could raise interest rates before the end of the year has also helped the Aussie, but with interest rates already at an 11 year high of 6.50 percent, how much further can rates rise? The market is currently pricing in a 100 chance that rates will be increased over the next 3 months. As we all know, these expectations can turn on a dime, but for the time being economic data does support tighter monetary policy. RBA Governor Stevens has maintained a hawkish bias for some time and looking at the data it isn’t hard to understand why. Economic growth is at multi-year highs with booming exports and consumer spending trends promising little reprieve; while core inflation has hovered just below the central bank’s tolerance limit since peaking in 2006. These trends were the basis behind the RBA’s last quarter point rate hike in August. However, just as uncertainty has crept into the financial markets and economic data, so too has the outlook for monetary policy. The global trend towards higher rates is starting to falter with both growth and inflation across the globe cooling. The Federal Reserve has set the tone by cutting the Federal Funds rate 50 basis points. A follow up from another major central bank like the European Central Bank or the Bank of England, may be just the encouragement RBA members need to drop their hawkish bias. Should this happen, we may finally see a top in the Australian dollar. However in the meantime as long as monetary policy remains hawkish, the Australian dollar should remain firm.
[B]Keep an Eye on Gold[/B]
Talking about the Australian dollar without talking about Gold would be a big overlook because the rise in gold prices was probably an even bigger driver of Aussie dollar movements over the past three months than economic fundamentals. From the beginning to the end of the third quarter, gold prices climbed 16 percent or approximately $100 an ounce, to highs not seen in over 27 years. As the world’s third largest producer of gold and the world’s largest exporter of coal, Australia stands to benefit significantly from Chinese demand. Should commodity prices continue to rise, so will the Australian dollar. If $750 an ounce proves to be an unsurpassable barrier however, then so will 95 cents in the Australian dollar.
Meanwhile it is important to mention that agricultural producers in Australia are struggling. Though inflation in this sector has been just as astronomical as many of its durable counterparts, output from Aussie firms has been lacking due to the worst draught in over 200 years. This has cut into many valuable categories that have contributed to growth in the past such as lost production in live stock (Australia is the largest beef exporter), wheat, wool and cotton. This has undoubtedly dialed back the growth potential for the Australian economy and the Australian dollar.
[B]A Risky Bet[/B]
Looking ahead, rising volatility and lingering doubts over the health of credit markets may prove to the main saboteurs of Aussie strength. Though financial markets erased most of the losses that the tumult in credit markets caused by the end of the third quarter, the full effects of the problem have yet be evident. For starters, economic data has yet to measure the period’s impact. It may be that the economy has already applied the breaks, yet economists and traders will not be aware of the situation for months. On the consumer level, spending will undoubtedly be impacted by a dip in optimism; and the cost behind financing large purchases and taking a mortgage will undoubtedly be reevaluated with lenders having to raise their rates even further above the current benchmark to cover any undue risk.
While these trends may slowly eat away at economic growth and in turn affect the currency through standard fundamentals, there is more direct risk in the form of the carry trade. What was once a golden ticket for currency traders, the popular carry trade is starting to take on a status more akin to position trading. Over the two months when credit market difficulties sent shock waves through global markets, the highly leveraged, over extended carry trade was quickly unwound to shore up balance sheets and free up capital. All of a sudden, the passive collection on interest rate differentials was not appetizing enough to sustain multi-decade and record highs across the FX market. This wave of risk aversion was largely the culprit behind the 11-big figure drop in AUDUSD and while these losses were recovered before the third quarter was closed out; the memory of losses incurred during that period will not be easily forgotten. As the Australian dollar rises, the risk of intervention by the Reserve Bank of Australia will grow as well, but as we have seen many times in the past, central bank intervention usually does not have a lasting impact on the currency.
Heading into the closing months of the year, Australian fundamentals are still strong. The economy is running at three-year highs with export activity, business investment and consumer spending ready to extend the run. What’s more, the Aussie’s central bank has added yet another 25 basis point premium to the benchmark lending rate to further enhance the currency’s carry trade status. However, these trends are finding themselves on increasingly unstable ground. Risk arising in basic lending practices has noticeably slowed other economies and threatens to do the same in Australia. What’s more, with central bank’s responding to the growing air of uncertainty and the cooling trends of expansion with an increasingly dovish slant, the persistently hawkish RBA is increasingly sticking out like a soar thumb. With AUDUSD testing multi-decade highs, steady economics, the trend of gold prices and interest policy will be increasingly important in winning further gains.
[B]AUDUSD Technical Outlook[/B]
Near term, an AUDUSD correction is due. The rally from .7673 is in its 5th wave (much like the USDCAD decline from 1.0866), daily RSI is divergent with recent highs and overbought, and price is approaching a potential resistance line drawn off of the May 2006 and July 2007 highs. That line is just below .9100 (about 100 pips from current price). A correction could bring the Aussie back to the 9/21 low near .8600 or the 38.2% of the rally from .7673, which is near .8500. A decline to these levels would offer the opportunity to position for a test of the confluence of lines shown on this chart near .9500. If the decline from near current levels unfolds as an impulse (rather than a correction), then we will favor the downside. Developments are always updated in the daily technicals.

[B]Written by DailyFX Research Team[/B]