Why Is Shorting The AUD Vs. The USD A Good Idea?

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Includes: FXA, UDN, UUP
by: Citylytics

Summary

The AUD benefited in the recent period mainly on the back of the USD weakness.

The Reserve bank of Australia sharpened its wording against the strong AUD on their latest meeting at the beginning of the month.

The verbal interventions from the Reserve bank of Australia combined with Fed rate hike in December will lead to exchange rate correction in the rest of the year.

The AUD (Australian dollar) recently benefited from positive market sentiment and more importantly the USD weakness. Meanwhile, the RBA (Reserve Bank of Australia) kept its cash rate unchanged at 1.5% in order to further boost labor market and inflation. The governor Philip Lowe has sharpened his wording against the strong AUD in August and stated the following: "The Australian dollar has appreciated recently, partly reflecting a lower US dollar. The higher exchange rate is expected to contribute to subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." However, the AUD continued trading at the almost unchanged levels in the aftermath of the meeting on the back of otherwise optimistic assessment of the economy.

Chart 1: The AUD/USD movements

Source: Bloomberg

There are two main reasons why I expect to see and AUD/USD correction in the rest of the year. First of all, the RBA is clearly unhappy with the recent AUD rise and they will further use verbal or even actual FX interventions against the domestic currency in order to prevent excessive appreciations. The commodity sector remains crucial for export and continuously low commodity prices are harming the Australian trade. The latter is additionally accentuated with the recent AUD rise.

Chart 2: The IMF commodity price index

Source: Bloomberg

The second and the more important reason for correction is the expected near-term USD rebound. The market is currently not pricing any more rate hikes from the Fed this year. The latter can be seen in the Fed funds futures pricing that currently implies that the Fed fund rate will be at the upper bound of the current target range by the end of this year. However, strengthening labor market combined with recent growth acceleration should be enough to convince the Fed to deliver one more rate hike this year. Also, there is still enough time for inflation to pick up on the back of weaker dollar. The July's CPI release for the US is scheduled for this Friday and it case it outperforms market expectations (+0.2% mom, 1.8% yoy) there is high chance that we will see a strong USD rebound. In case this occurs, we will see an immediate correction from the current AUD/USD levels. Otherwise, the RBA's verbal interventions against too strong AUD and another 25bp rate hike from Fed in December will lead to a correction in the rest of the year.

However, accelerating growth and the labor market recovery might force the RBA to hikes rates as soon as in first half of 2018. Let us not forget that they are still increasingly worried about booming property market and they don't want to overheat the economy. Once the market begins to price RBA rate hike (not likely before the 1Q18), the AUD will mostly regain ground against the USD.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.