Time To Pare Back Bullish Positions In The Australian Dollar

Includes: BHP, FXA, FXY, UUP
by: Dr. Duru

Almost two weeks ago, I noted that as long as the Australian dollar (NYSEARCA:FXA) maintained its stubborn strength, it made sense to play the currency long versus the weakening Japanese yen (NYSEARCA:FXY). Now, the Australian dollar has already traded to the top of the trading range for AUD/JPY.

The Australian dollar returns to 2012 highs against the Japanese yen; top of the trading range looms

With the Liberal Democratic Party winning in a landslide in Japan's parliamentary elections, it seems the current trends are ready to accelerate. The LDP has promised to get more involved in monetary policy, calling for infinite printing by the Bank of Japan until inflation returns to the economy, and to further ramp up fiscal stimulus.

However, the election victory was well anticipated, and markets have a habit of selling the news in cases like these (just see the U.S. Presidential election for a great recent example). So it makes sense to pare back long positions in AUD/JPY and wait for the market's next moves. I am expecting a pullback that will offer fresh buying opportunities at lower prices, but a breakout would motivate adding back at higher prices (with a smaller position).

In the meantime, the Australian dollar is also trading at upper limits against the U.S. dollar (NYSEARCA:UUP).

Australian dollar trades to its current downtrend against the U.S. dollar

The U.S. Federal Reserve increased monetary stimulus to the U.S. economy last week. The U.S. dollar weakened in response, but only slightly. In fact, the dollar index is now trading exactly where it was when QE3 was announced in September (the QE3 price).

The dollar index has gone nowhere since the Federal Reserve announced QE3

It is this resilience in the U.S. dollar that keeps me short AUD/USD with a small position. I am expecting the downtrend to hold (note I also expected 1.05 to hold as resistance). The Australian dollar's resilience is going to continue to frustrate the Reserve Bank of Australia's (RBA) attempts to bring the currency down through lower interest rates. At this point, it seems clear weakness in the economic numbers are the only thing that will bring down the currency unless other major economies somehow ramp up in 2013.

For example, Australian cotton farmers are not making money despite the relative health of the global cotton market. The IMF's rosy outlook for the Australian economy is also strongly conditioned on the ability of the RBA to weaken the currency. I expect 2013 to feature another strong bear/bull battle over the Australian dollar. Through it all, it is helpful to remember that currency has remained range-bound against the yen and the U.S. dollar for the past 2-3 years…in other words, no need to get really excited until a breakout (or breakdown) finally happens.

As always, the big wildcards for the Australian dollar are commodity prices. On December 3rd, the RBA had this to say about its index of commodity prices in November:

Preliminary estimates for November indicate that the index rose by 1.7 per cent (on a monthly average basis) in SDR terms, after falling by 2.9 per cent in October (revised). The largest contributors to the rise in November were increases in the prices of iron ore and coking coal. The prices of rural commodities also increased, while the prices of base metals declined in the month. In Australian dollar terms, the index fell by 0.1 per cent in November.

Over the past year, the index has fallen by 11.6 per cent in SDR terms. Much of this fall has been due to declines in the prices of coking coal and iron ore. The index has fallen by 16.3 per cent in Australian dollar terms over the past year.

The correction over the past year has been steep but not (yet) enough to significantly weaken the currency. Moreover, the commodity index remains above its pre-crisis peak.

RBA Index of Commodity Prices

Source: Reserve Bank of Australia

If the recent sharp run-up in the shares of diversified Australian commodity giant BHP Billiton Limited (NYSE:BHP) is any indication, the year-long decline in commodity prices is set to moderate, not accelerate.

BHP broke its recent downtrend after the Fed announced QE3 - it has not looked back since

Source for graphs: FreeStockCharts.com

Note well that while the U.S. dollar has not responded to QE3, BHP has. The stock broke out from its recent downtrend from all-time highs right after QE3 was announced. This line held as support even after BHP soon pulled back. The stock has not looked back since then. In September, I noted how BHP's retest of its QE2 price marked a great buying opportunity. That line held as strong support, and BHP is now up 24% since then. Like the Australian dollar, I think it is time to pare back positions in BHP, but I think this stock should be a key indicator for sentiment regarding the health of the commodity complex and ultimately the Australian dollar.

Be careful out there!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BHP 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.

Additional disclosure: In forex, I am long AUD/JPY and short AUD/USD.