Australian Dollar Clings To Breakout As Current Catalysts Support Upward Trend

On July 30th, the Australian dollar made a clean breakout against the U.S. dollar (NYSEARCA:FXA). At that time, I stated I was finally ready to reposition for what could be an extended rally. My final milestone was Australian retail sales growth released on August 1st. Those numbers came out stronger than expected (1.0% versus 0.7% consensus), but the Federal Reserve provided the larger catalyst earlier in the day.

As the U.S. dollar index (NYSEARCA:UUP) rallied off its 50-day moving average (DMA) in response to the statement on monetary policy, the Australian dollar (not part of the index) weakened as well. The end result was a temporary drop below the April high and then a rebound right back to that level.

Click to enlargeThe U.S. dollar index pulls back from a major breakout above its QE2 reference price but still finds support at the 50DMAClick to enlarge

The U.S. dollar index pulls back from a major breakout above its QE2 reference price, but still finds support at the 50DMA

Australian dollar clings to its breakout against the U.S. dollarClick to enlarge

Australian dollar clings to its breakout against the U.S. dollar

Given the current pattern in the uptrend, I now expect the Australian dollar to drop to the 1.03 level or so before staging another rebound. My overall bearishness on the Australian dollar still has a very short remaining shelf life, but I am also not bullish. In fact, until fresh catalysts appear on the economic front, I think it is much more useful to think of the Australian dollar's prospects versus individual currencies rather than in totality.

While the Australian dollar has made halting progress against the U.S. dollar, it has really beaten up the euro and the British pound. Central banks in both regions are now easing monetary policy much more aggressively than the U.S. Federal Reserve, making the euro (NYSEARCA:FXE) and the pound (NYSEARCA:FXB) more attractive as funding currencies in carry trades. The precipitous charts say it all.

The Australian dollar soars against the euro (EUR/AUD plunges)Click to enlarge

The Australian dollar soars against the euro (EUR/AUD plunges)

A steep decline for GBP/AUDClick to enlarge

A steep decline for GBP/AUD

Australian stocks (in general) also show little sign of experiencing a fresh decline. The Australian stock market just hit 10-week highs. The iShares MSCI Australia Index Fund ETF (NYSEARCA:EWA) appears to have stabilized above ITS QE2 reference price.

The ETF of Australian stocks has gone nowhere for almost three years but it appears to have stabilizedClick to enlarge

The ETF of Australian stocks has gone nowhere for almost three years, but it appears to have stabilized

While the Reserve Bank of Australia (RBA) will likely repeat its conclusion that the Australian dollar is over-valued at its next monetary policy meeting on August 10th, it will be hard-pressed to drop interest rates further without a fresh move downward in commodity prices. Without lower rates (or the expectation of lower rates), it is unlikely the Australian dollar will experience a fresh round of selling pressure. I am guessing that the Australian dollar has little additional upside against the U.S. dollar as the U.S. dollar overall seems ready to remain at elevated levels.

Commodity prices always loom large when considering prospects for the Australian dollar. While the domestic economy appears to be weakening slightly, the commodity sector remains relatively strong. The RBA Index of Commodity Prices increased slightly in July (1.3%) after a marginal increase in June. This index is off its peak, but it remains well above pre-recession highs. With China stimulating its economy again, this index could stabilize around current levels or even continue to creep upward. So, on balance, macro conditions still lean in favor of the Australian dollar.

RBA Index of Commodity Prices (as of July, 2012)

RBA Index of Commodity Prices (as of July, 2012)
Source: RBA Index of Commodity Prices

So, overall, I am now marginally bearish against the Australian dollar. As I look to trade more bullishly again, I am keenly interested in fading pops in EUR/AUD and GBP/AUD - something I have finally started doing very tentatively given the trends downward are already quite extended.

One looming wildcard could be the foreign reserve actions of the Swiss National Bank (SNB). In recently released numbers, the SNB reported a substantial increase in foreign reserves as it continues to struggle to hold the 1.20 floor for the franc against the euro (EUR/CHF):

"Since the beginning of the year, the SNB's balance sheet has increased by CHF 89 billion to CHF 439 billion. Foreign currency investments alone advanced by CHF 108 billion. A large part of this increase is due to foreign currency purchases made during the second quarter to enforce the minimum exchange rate against the euro."

In the second quarter, the SNB's foreign currency investments surged sequentially against every listed category (major currency) except the British pound. Foreign currency investments in the euro jumped 77%. Foreign currency investments in "other currencies" - including such currencies as the Australian dollar and the Swedish krona - surged 50%. Assuming the SNB will want to further diversify its holdings out of euros and into other currencies and assuming that the SNB will have to continue to fight to keep the floor, it seems that the Australian dollar should continue to enjoy some strong flows from the SNB. It is not possible to tell from these numbers how much support the Australian dollar will receive or has received to-date, but I think it is prudent to assume that a non-trivial amount of the SNB's diversification strategy is targeted at the Australian dollar. Traders should position accordingly. I am re-positioning by dialing back my bearishness until a new catalyst emerges.

Disclosure: I am long EWA.

Additional disclosure: In forex, I am net short Australian dollar (with caveats as explained above). Long EUR/CHF.