Short FXA When Rio Tinto Falls

The AUDUSD (NYSEARCA:FXA) has been on a relentless push upwards since the beginning of the month, with a high of 1.0579 on the 12th. This surge caught me by surprise, stopping my position out at 1.052 (you can see my year to date trading history here). The speculative traders at the CFTC's have been on the correct side of the trade, net long since July. In the chart below, the yellow line and right hand axis it the exchange rate, and the blue line the net short/long position of the professional FOREX traders.

This level of Net Non-Commercial Positions in the AUD is also at 4 year highs. The last time professional FOREX traders were this long the AUD was in March 22nd, 2011 when the AUD was trading at 1.0011. It went on to rally to 1.0579 which I've highlighted via the red line in the chart below.

When this is compared to retail traders at OANDA, a difference between professional and retail traders emerges which explains why majority of retail traders lose money.

As opposed to professional FOREX traders, retail traders have been net short of the since mid-November and largely short the latter half of this year. This pattern is consistent throughout all FOREX currency pairs, with retail investors being mean reverting and professional traders being trend following. Evidently, trend following is a more profitable way to trade. Also of note from a public policy perspective, retail investors reduce volatility rather than exacerbate it, a generally sought after attribute of markets by politicians.

In any event, when you find yourself against the professionals and with the retail investors, ensure you take extra precautions in your risk management.

The Recent Economic Data Conflicts with the Price Action

The data out of Australia has been largely negative, other than an employment numbers beat at the beginning of the month:

Even a 25 basis point rate cut followed by a poor GDP numbers and a miss on the change in trade balance wasn't enough to reverse the trend in the AUDUSD.

The AUDUSD also acts as a proxy for economic events in China, given the amount of trade between the two nations and the currency controls on the Chinese Yuan. Interestingly, there has been sparse positive news on China as well. Especially of note is the decline of new loans, as credit drives asset prices which drives economic activity. This relationship is also known as the Theory of Reflexivity from the legendary trader George Soros. The only caveat is China has an extensive shadow banking system that may be making up for this decline in loans. Below is the calendar of China's events in December.

It is important to remember that all this data is backward looking. For instance, the M2 Money Supply released on the 11th had to be compiled and reviewed by the appropriate government agencies before being released; therefore it is ancient history by the time we see it and have very little to do with today's capital flows.

There are market based indicators that assist in detecting capital flows, which are to follow.

Capital is Flowing into Equities, Out of Bonds and Iron Ore is Rallying

Equity markets are smaller than bond markets, therefore I was surprised to see that the AUD had been rallying despite a selloff in bonds. Every tenure, from 2yr to 15yr, has seen prices fall and yields rise. The bar graph under the Range column demonstrated this, with the blue dot (price now) being to the right of the red dot (historical average price).

The equity markets have rallied strongly in December, up 1.4% thus far in the month. This in part explains the strength of the AUDUSD in spite of the bond selloff. In the chart below, I've included the Australian equity index in blue (ASX), the AUDUSD exchange rate in yellow, and the 2yr and 15year bond prices in green (light green for the 2 year, dark green for the 15 year).

The ASX and the AUDUSD have been highly correlated, with the recent spike in AUD to the 1.0579 level coinciding with a spike in bond purchases.

The equity market alone would unlikely draw in the capital flows required to offset the selloff in bonds, but there is one other important real time variable, the price of iron ore. Like the ASX, it has been rallying, as seen in Rio Tinto's stock price (blue) and Iron Ore's spot price (red). I've included the AUDUSD price (yellow) to demonstrate how the price action interrelates between the 3.

Australia is the largest exporter and second largest producer of iron ore after China, producing approximately 17% of the world's total iron ore. It also makes up a significant portion of their exports, totaling $61 billion AUD in 2011, which is why the price of iron ore is important to the AUDUSD exchange rate. The higher the price of iron ore, the more demand for iron ore, the more AUD required to purchase each unit of iron ore from the Australian mines, the higher the AUDUSD exchange rate.

The Trade: Short the AUD when Rio Tinto's Stock Price Reverses

As I alluded to in the introduction, I was just stopped out of a short AUDUSD trade, but I do plan on re-entering it. After examining both historical and real time data, the key indicator I'll be watching for is a reverse in iron ore`s price as indicated by Rio Tinto's stock price. Of course, this will be in addition to a number of other data points, as the world is a complex place that cannot be broken down to one indicator. But historically Rio Tinto has been a good leading indicator of the AUDUSD, such as in September, and the AUD is trading at the top of its recent range, suggesting a short term reversal may be in the cards.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FXA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.