Seeking Alpha

AUD/CAD: Downside Risks Outweigh Upside Potential

by: Hedge Insider
Hedge Insider
Long/short equity, value, macro, volatility

The AUD/CAD pair has risen recently, but still remains within its short-term trading range (noticeable on a daily candlestick chart).

Speculators are still bearish on the pair, although short positioning is no longer as extreme as it was in 2019.

Given the negative interest rate differential on the AUD/CAD pair and the near-term risk of Australia lowering rates further, the optimism apparently still priced into the bond market seems inappropriate.

As gold is an important export for Australia and oil an important export for Canada, the down-trending ratio between gold and oil prices would lend further support to a bearish thesis on AUD/CAD going forward.

As the pair currently trades at the midpoint of its prevailing trading range, further downside below this midpoint is likely to send the pair to the bottom of its trading range at about 0.8836. Further downside below this level should not be ruled out either.

In the last article I wrote on the AUD/CAD pair, which is the value of the Australian dollar expressed in terms of Canadian dollars, I believed that the pair offered short-term upside potential with longer-term downside. Since that article's publication on November 2019, AUD/CAD has been mostly range-bound, within the trading range previously identified.

The chart below is a daily candlestick chart showing recent AUD/CAD price action within its prevailing trading range (the shaded area). The vertical red line draws attention to the date of my last article's publication in November; the prediction has mostly been correct thus far, however we would now want to see some follow-through to the downside.

AUD/CAD Trading Range

(Chart created by the author using TradingView. The same applies to subsequent candlestick charts presented herein.)

As we can see, AUD/CAD is now trading roughly at the center of its short-term trading range. An updated chart is provided below, which provides a horizontal line to illustrate the midpoint of the current trading range at 0.8990.

AUD/CAD Price Action versus Current Trading Range Midpoint at 0.8990

The price, at the time of writing, has once again found its way to the midpoint, which is serving as an apparent area of support. Interest rates are important as ever; the stronger interest rate of one currency, the more likely that currency will appreciate, all else equal.

This is because higher interest rates improve the ongoing net interest income (or reduce the ongoing net interest expense) associated with holding a particular currency in terms of other currencies. The updated chart below illustrates the difference between the one-year government bond yields of Australia and Canada (see the red line, set against the far-right y-axis). It is currently in negative territory at about -0.82%.

AUD/CAD vs. One-year Interest Rate Differential

Notice both that the yield spread roughly correlates with the price action of the pair (as it usually should) and that the yield spread is most recently making lower highs (about -0.80% on December 31, 2019, versus -0.78% on October 31, 2019; in other words, while the interest rate spread is still negative, the highs are becoming more negative in spite of recent bullishness in the spot price of AUD/CAD).

We may see further downside. Note that the short-term central bank rates of Australia and Canada are both positive at +0.75% and +1.75%, respectively. We can reach an "implied interest rate spread" of negative 100 basis points (i.e., 75 basis points for Australia minus 175 basis points from Canada's short-term rate), which is still over 10 basis points lower than the bond market's current short-term spread.

Further downside in the yield spread could see a further drop in AUD/CAD below the midpoint of the current trading range at 0.8990. For short positions to ultimately profit, we would then ideally see this midpoint become a source of resistance, to enable a further follow-through of the downside, at least to the bottom of the current trading range at about 0.8836.

Commodities are also important for the Australian dollar and the Canadian dollar. I recently wrote about the Australian dollar versus the New Zealand dollar, an article in which I drew attention to Australia's gold export exposure. Given Canada's oil export exposure, North American (and global oil) prices tend to correlate positively with the international value of the Canadian dollar.

Canadian Export Exposures by Category

(Canadian export categories, each presented as a percentage of total exports. Source: Trading Economics.)

Therefore, while only a simple tool, we can usefully monitor the ratio between gold and oil prices to gauge the potential for a breakout or breakdown of the AUD/CAD currency pair. This can be used to support (or reject) an existing thesis; our current thesis would suggest further downside in the AUD/CAD pair, therefore the chart below should be of interest.

AUD/CAD vs. Gold and Oil Prices

The chart above includes the crimson line, set against the far-right axis, which is the ratio between the gold price (in U.S. dollars) and WTI oil prices (in U.S. dollars). The blue line is the 50-day moving average.

We would expect the Australian dollar to strengthen with a sustained appreciation of gold and the Canadian dollar to strengthen with a sustained appreciation of oil (given their respective export exposures), and vice versa. The relationship between both provides us with a potential trading indicator. Notice in the above chart that our gold-to-oil ratio is still below its 50-day moving average, which possibly strengthens our bearish view on AUD/CAD.

To add further color to the above, the chart below shows the 20-day moving average of our ratio (in green) and the 50-day moving average (in red). This paints a simpler, but perhaps clearer, picture.

AUD/CAD vs. Gold/Oil Ratio

In any case, the key takeaway point is that the current relationship between gold and oil prices is indicative of further downside for AUD/CAD.

However, you can also notice that during much of 2019, our ratio was rising and above its 50-day moving average, in spite of the AUD/CAD pair struggling to sustain higher levels. We should consider two factors here: firstly, the market may be otherwise overwhelmingly bearish on the AUD, regardless of whether commodity markets support upside, and secondly, we should not forget that this currency pair is still fundamentally negative carry (the interest rate spread is negative, hence making short positions more attractive).

We can confirm this perspective per short positioning data from the Commodity Futures Trading Commission (see here); the data shows that speculators have been heavily "short" the Australian dollar throughout much of 2018 and all of 2019 (and in 2020 thus far).

AUD/CAD Short Positioning

Going forward, the pressure is likely to remain on the Australian dollar. Added pressure recently has come in the form of natural disaster: an extremely unfortunate situation which has led to a loss of both human life and wildlife, and brought "historic levels of destruction" to the country (see news article linked to above from NPR).

This negative chain of events could force the Australian central bank into action, encouraging them to loosen monetary policy further. That is a speculative thought, but still a very much possible conclusion to assist the Australian economy in the short term (the next RBA meeting is on February 4, 2020, which is when any decision would be made). Still, given that the bond market is still technically optimistic, we could well see a (further) reduction in the bond market's optimism in the short term, and possibly even see the bond market price in some pessimism (ahead of the February 4 central bank meeting).

Ultimately, the downside risks for AUD/CAD currently appear to outweigh any upside potential. We should expect lower prices in the near term.

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.