AUDUSD: A Big Week Ahead For The Australian Dollar

Summary

Australian inflation targets appear to have been softened, leading to the chance of further rate cuts diminishing.

We only see the Australian dollar weakening as a result of events in the United States. The RBA is most probably helpless now.

Whilst the odds of a rate hike by the Fed are slim, we feel a surprise hike could send the Australian dollar down to 72 U.S. cents.

Our 12-month target of 65 U.S. cents is still very much in play, making it a great long-term short.

It's fair to say there is a big week ahead for the Australian dollar (NYSEARCA:FXA) with the Reserve Bank of Australia releasing its meeting minutes tomorrow, the Bank of Japan making its interest rate decision a day later, and then there is of course the Federal Reserve's rate decision on Wednesday. All in all, it looks likely to be a volatile week for the AUD/USD pair, which we believe has the potential to send the Australian dollar much lower.

Not a great start.

Considering the importance of the week ahead, the Australian financial markets couldn't have got off to a worse start. A technical glitch at the Australian Stock Exchange meant the market opened around 90 minutes late. Then again at 2:30pm local time the market ground to a halt again and stayed that way. Finishing the day without official closing prices. No details have been given about the glitch, though cyber threats have been ruled out. The operators of the exchange are confident that the market will open as normal on Tuesday.

The Treasurer speaks about inflation.

Whilst the market was shut Scott Morrison, the Treasurer of the Turnbull government, spoke about his agreement with the Reserve Bank of Australia. He stated:

"Both the Reserve Bank and the government agree that a flexible medium-term inflation target is the appropriate framework for achieving medium-term price stability. They agree that an appropriate goal is to keep consumer price inflation between 2 and 3 per cent, on average, over time. This formulation allows for the natural short-run variation in inflation over the economic cycle and the medium-term focus provides the flexibility for the Reserve Bank to set its policy so as best to achieve its broad objectives, including financial stability. The 2-3 per cent medium-term goal provides a clearly identifiable performance benchmark over time."

Three years ago it was a little different.

Three years ago the previous treasurer Joe Hockey and the Reserve Bank agreed on the following:

"In pursuing the goal of medium-term price stability, both the Reserve Bank and the government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle. This formulation allows for the natural short-run variation in inflation over the cycle while preserving a clearly identifiable performance benchmark over time."

No more rate cuts?

Whilst the differences may be subtle, the ramifications are quite substantial. Previously the 2 to 3 percent inflation target was on average over the cycle, whereas now it has become on average over time. We feel this is an indication of no further rate cuts coming from the Reserve Bank. It appears as though they plan on being patient and will not panic if inflation is lower in the short term.

This is probably a wise move. After all, rate cuts have done very little to weaken currencies across the world to assist with increasing inflation. You only need to look at the Bank of Japan and the Japanese yen (NYSEARCA:FXY) to see that. The U.S. dollar (NYSEARCA:UUP) is king and it will be rate rises in the United States that ultimately dictate where the Japanese yen and the Australian dollar go.

Will the Federal Reserve raise rates?

We are sitting on the fence with this one. We would love to see rates start on a pathway to more normal levels, but the market appears to have priced this one out of the equation. The weak economic data, such as retail sales last week, appear to have caused this. But ultimately nobody knows what data the Fed is paying attention to. There is a lot of positive data out there that could justify a rate rise, but at the same time there is data that could warrant holding fire.

According to the previously dovish Goldman Sachs, the chance of a rate rise this week has fallen to below 5 percent. Its analysts have pointed to the fact that the FOMC will "almost never surprise with a hike." The lack of effort made by the Federal Reserve to raise market expectations of a hike should be an indication of no rate hike coming.

What next?

Despite this we feel that the long-term short of the AUD/USD pair is a great move right now. The market is not expecting a rate hike, therefore we see very little risk of the Australian dollar climbing considerably if rates stay on hold. We see it topping out around 76.2 U.S cents, whereas if there is a surprise cut we can see the Australian dollar dropping to as low as 72 U.S. cents as shown below.

Click to enlarge

Sourced from DailyFX

Considering our 12-month view of the Australian dollar dropping down to 65 U.S. cents, we feel this week represents an opportunity to begin shorting the AUD/USD with a long-term view. Investors that are happy to sit on a trade for a significant period of time will no doubt be rewarded. Those that are only in it for the short-term would be better off staying out of this one in our view.

All the best with your trades!

Disclosure: I am/we are short FXA.

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.