AUD/USD - Breaking A 3-Year Consolidation Area

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Includes: CROC, FXA
by: Dmitry Lifatov

Summary

The Australian economy performs very well, with almost all leading macroeconomic indicators pointing to further growth.

The U.S. economy is gradually recovering from soft macroeconomic readings in Q2 2017, signaling an improving outlook for growth in H2 2017.

The main driver explaining the future of the AUD/USD exchange rate dynamics will be the prospects for further interest rate hikes in the U.S. economy this year.

Currently, we don't see any barriers to further gains in the AUD value. The pair has successfully tested a 0.7800 level and now is ready for a strong upward movement.

AUD/USD entered a period of consolidation in June 2015, bouncing off 0.7800-0.6800 for three consecutive years, after a steep decline which started in September 2014 and which was caused by a collapse in commodity prices. In July 2017, the pair managed to break above a 0.7800 resistance level, and after a pullback in August 2017 is now ready to continue its further push higher.

So, let's examine the state of economies in both the U.S. and Australia.

Outlook for the Australian economy

The Australian Manufacturing PMI in July 2017 rose to 56.0, which is a pretty high figure, judging from historical data. For the Australian economy, manufacturing industry plays a relatively small role (just 6.5% of GDP in 2014), but for traders exactly this index has a vital significance for predicting the national economic health over the next 12-18 months. Services PMI also improves, standing at 56.4 in July 2017. So, the overall trend is positive and we expect an expansion of the Australian economic activity in the coming months.

Business optimism is also on the rise, with +15 points in July 2017 returning to the pre-crisis levels not seen since 2008. The only potential vulnerable area for the Australian economy is consumer confidence, which declines since the beginning of 2017. And this is indeed pretty dangerous because a broader economic upturn has not been yet translated into higher consumer sentiment, which may lead in the future to lower business activity (fewer sales to consumers) and ultimately weaker GDP growth. The probable reasons for such sluggish consumer optimism can include rising energy costs, deceleration in wage growth and an ongoing dual-citizenship debacle in the Australian Parliament. This divergence from other key leading macroeconomic indicators should be closely watched by currency traders for any improvements.

The Australian CPI in Q2 2017 fell to 1.9% y/y, down from 2.1% in Q1 2017. The core CPI showed a similar dynamics, rising only by 1.8% y/y. As mentioned in the recent RBA's statement, the reason for slower inflation growth is a higher exchange rate of the Australian dollar, which has already gained more than 11% since the beginning of the year versus the U.S. dollar and acts as a disinflationary force. PPI in Australia rose to 1.7% y/y in Q2 2017, up from 0.5% y/y in Q3 2016, signaling a strong upward trend.

The Australian unemployment rate fell to 5.6% in July 2017. The main expectation here is, however, that the rise in employment figures will be translated into a wage growth, boosting thus consumer confidence - the much anticipated desirable outcome.

The Australian GDP growth rate slowed to 0.3% in Q1 2017. The RBA expects a GDP growth in 2017 somewhere between 2% and 3%, citing higher exchange rate of the Australian dollar having an adverse impact on the national economy.

The RBA's interest rate policy is expected to remain unchanged, with some prospects for interest rate hike appearing only by late 2018.

Outlook for the U.S. economy

The July readings of the U.S. Manufacturing PMI showed a remarkable improvement, standing at the level of 53.3 points. In Q1 and Q2 2017, this indicator demonstrated a gradual decline; but now this trend is broken, calling for higher values in the coming months. The U.S. Services PMI also printed solid gains in August 2017, rising to 56.9 from 54.7 in July 2017.

The Consumer Sentiment Index rose to 97.6 in August 2017, which is the highest level since February 2017, reflecting more favorable personal finance prospects.

The U.S. CPI in July 2017 rose by 1.7% y/y, which is below market expectations. This can provoke some doubts over the possibility of the next interest rate hike this year, since this is the fifth consecutive month when the modest gain in consumer prices falls short of market expectations. The core CPI data stood at the level of 1.7% y/y, flat for the third month in a row, also adding to the doubts regarding the further Fed interest rate hike.

The producer inflation in the U.S. showed even softer data for July 2017, down to 0.1% m/m. Core PPI also printed a 0.1% drop in its July readings. The inflation indicators should be closely tracked by traders since they have a profound impact on the prospects for the future interest rate hikes.

The situation in the U.S. labor market is constantly improving, with the recent unemployment rate standing at just 4.3%.

Interest rate hikes is the most widely-discussed topic among economists and currency traders since this is what really matters. Minutes from the recent FOMC meeting showed an ongoing debate among Fed officials on the pace of interest rate hikes. The main argument to slow down the pace of increases is inflation, which lags behind a 2% Fed target. The speech at Jackson Hole delivered by Janet Yellen has lowered traders' bets on further interest rate hikes this year, but the situation is somewhat unclear and exactly the inflation figures can give the most important hint on the possibility of this move.

Summary

To sum up, from the exogenous point of view, the Australian economy is currently performing better than the U.S. economy, but the latter started showing some signs of recovery from the soft Q2 2017 macro readings. The key driver determining the mid-term AUD/USD exchange rate prospects is a pace of interest rate hikes in the U.S. Should the Fed slow down this pace and keep interest rate unchanged this year, Aussie will receive a strong upward incentive.

Technically, after a breakout of a 0.7800 level and a successful pullback, we do not see any barriers to further gains in the Aussie dollar exchange rate versus the U.S. dollar. September 2017 will be thus a perfect time to open buy orders in this pair.

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.