AUD/USD Third Quarter FX Outlook

Once again, the Australian dollar was one of the star performers in the currency market. Although it fell short of claiming the title of the biggest gainer (bowing to both the New Zealand and Canadian dollar?s stellar rallies), the unit enjoyed considerable appreciation in the second quarter.

By the end of the June, the Australian dollar hit an 18 year high against the US dollar and a 10 year high against the Japanese Yen. Even against the stalwart Euro, the Australian dollar rose 3.5 percent.
Looking back over the developments in the first half of the year, it is clear that there are a few big fundamental themes that will dictate price action over the coming quarter and beyond. One issue - long relegated to the background - that will likely come back into focus is commodities. A large exporter of natural goods, the Australian economy, and especially its export sector, look to benefit from high prices in a number of key commodities. Another issue that has not been in play for some time will be politics. A general election must be called before January of 2008, though many expect it to be much sooner. Regardless of when the actual vote will take place, the waves will begin early as candidates make their promises for economic reform. Finally, the most pressing matter for the Australian dollar (as it seems it is for the entire currency market) is interest rates. The Australian dollar enjoys a healthy bid that is perpetually anchored to the nation?s high 6.25 percent overnight cash rate (OCR). However, the central bank has not altered this rate since last November; and each meeting that ends in the same rate sparks greater doubt into the belief that the next move will be higher.
[B]Gold, Coal and Wheat A Supplement To Fiat Currency[/B]
The Australian dollar is a well known member of the commodity block - and for good reason. The nation and continent is a major producer of agricultural goods that are sold to China and other Asian countries as well as a producer of metals and energy commodities that are shipped to consumers the world over. In the past few quarters, the commodity appeal of the currency has taken a back seat as yield spreads grew in prominence. However, the influence these goods have on the Australian dollar?s exchange rate will always be in the background - and it may even come back to the forefront should carry trade interest diminish. Over the first half of the year, a number of the country?s key exportable commodities saw impressive increases in price. Sometimes referred to as the bread basket to Asia, Australian wheat exporters saw prices for their produce rally nearly 45 percent to $0.13 per bushel. However, the dramatic increase in global prices is partially a response to dwindling crops in Australia as the country comes off of the worst drought in two centuries. In addition to wheat both gold and coal also found support in Q2 of 2007. Australia is the second largest producer of gold in the world, benefiting greatly from gold?s rebound back towards the $700/ounce barrier . Coal, like many other energy commodities, has grown in price and demand. Industrial giants like China and India have led the international call for energy thanks to their own incredible pace of growth. Looking ahead, as global growth rates remain heady, demand for Australia?s key commodities looks to continue its support of the nation?s currency.

[B]Political Swells on the Horizon[/B]
Over the next three to six months, Australians will be courted by politicians as the general election approaches. Since the nation runs on a parliamentary system, there is no set time for the actual vote; but the cut off is set for January 19th, 2008. However, most political pundits suspect it will happen in the second half of this year with many expecting the announcement to come after the APEC Economic Leaders? Meeting held on September 8th-9th. In recent pollings, issues like the economy (67%) and taxation and interest rates (54%) have clearly waned in the public?s eye. This is due predominately to the strong levels of employment, corporate revenues and overall growth. In these economical factors? place have risen Medicare (83%) and education (79%). This is important to take note of since it could reshape the landscape as the new candidate could be decidedly less business-oriented than current Prime Minister John Howard and therefore dim the outlook for the Australian economy and its currency. Polls from mid-June see the Labor Party retaining control of the government with Kevin Rudd a favorite for the top spot after taking the party reigns.
[B]An Economic Envy[/B]
The world?s largest economies have reported enviable growth over the past months, and Australia?s was no exception. In the first quarters, the twelfth largest economy reported annualized growth of 3.8 percent. This was the fastest pace of expansion in nearly three years. A quick look at recent economic data reveals that the components to this strong cycle are broad. At the top of the list is the consumer. Household consumption grew 1.5 percent in the first quarter as wage growth advanced 1 percent over the same period (a near record) and unemployment held at a 33-year low of 4.2 percent. Looking ahead, this vital element of expansion does not seem to weaken anytime soon. This outlook is partially supported by the health of the business community and their efforts to increase investment to keep up with demand. Investment by Australian firms grew 7.6 percent in the opening months of the year - a trend that the near four-year high for the June NAB Confidence index looks to carry into the future. On the other hand, there are certainly cracks in the foundation. The housing sector has started to falter under the heavy burden of high interest rates. Dwelling construction cooled to a 1.6 percent rate of expansion in the first quarter. This has been topped by recent drops in new home sales and building permits all while overall affordability has sunk to 20-year lows. As this is a leading gauge for consumers? tolerance for lending rates and willingness to spend, further declines could guide the broader economy lower and the currency with it.
[B]Keeping Ahead Of the Curve[/B]
Perhaps the most pressing matter for the Australian dollar in the months ahead is interest rates and whether or not the Reserve Bank of Australia will raise the benchmark lending rate again this year. In the first half of the year, interest rate differentials were the unofficial weathervane for the currency market. As liquidity flooded the market and volatility shrank to historical lows, investors the world over sought their returns in passive carry trades. When searching for currencies with a high yield and respectable liquidity, the Aussie dollar always came up as a top candidate. However, in recent months, the safety of the carry trade has come under fire. With investors taking note of the large potential risk in holding overbought currency pairs, the requirements for adding more capital have changed. Looking ahead to the second half of the year, the restive market will likely need the promise of future rate hikes and widening yield differentials to stay with the relatively risky trades. Subsequently, the outlook for the Australian dollar crosses may run into some trouble in the near-future. The RBA?s monetary policy group is still considered hawkish, though economists and futures markets are not betting on another boost to the 6.25 percent overnight lending rate this year. What?s more, the ingredients for a future hike are starting to disappear. Consumer level inflation is back within the tolerance band and is closing in on the central bank?s target rate. Should consumer spending take the lead of housing and start to cool in the months ahead, a hawkish bias could quickly turn to neutral then dovish and in effect send the Australian currency tumbling.
[B]Conclusion[/B]
In the coming months, the risks are clearly defined for the Australian dollar. While many of the key components to its record-breaking ascent in the first half of the year are still in play, a few are starting to slow or falter. The key to the future direction for the currency will no doubt be the outlook for the nation?s lending rates. Though the RBA?s monetary policy group is still considered hawkish, there is little premium given to another 25 basis point rate hike anytime this year. And, while the mild-hawkish regime adds up to little, economic trends will continue to cut into expectations while interest rates in other countries? policy bearings threaten to close the gap with Australia?s benchmark 6.25 percent lending rate. Growth and inflation will play leading roles in guiding interest rate expectations as well. At the same time, while the market finds its way through the interest rate fog, strong consumer spending and demand for Australia?s commodities will work to keep the currency buoyant.
[B]Technical Outlook[/B]
We mentioned last quarter that the AUDUSD may extend towards .8915. The pair is pushing up against .8800 now as the pair works higher in a 3rd wave within a 5 wave rally that began at .7268. The third wave is in its 5th wave so near term upside potential is limited. A correction in a 4th wave is expected to play out before the AUDUSD completes the rally from .7268. In summary, we are looking for a down-up scenario in the next few months before a more significant top is put in place. Potential support for the expected wave 4 correction is at the 6/26 high (.8510).
[B]AUD/USD Daily Chart (Source: TradeStation 8.2)[/B]