Wednesday, October 29, 2014

An Aussie breakout | …to the upside?

Australian terms of trade are in deficit. In other words, Oz spends more on imports than it earns on exports. One reason for this is the recent dramatic fall in hard commodities prices, led by oil and Iron Ore, which Australia sends in large quantities to China. But China is also adjusting to a lower growth economy than heretofore, so these exports will be less in the future, certainly in value terms.

Down Under, inflation is low and falling. Employment is not anywhere near where the authorities would like to see it. Reserve Bank of Australia members are on record as saying that the currency is still overvalued.

Despite all of these fundamentals being less than stellar, the Austrian dollar yesterday seems to have broken up out of a rising triangle pattern bounded, to the upside, by the 25 day Exponential Moving Average (EMA) and to the downside by a line drawn through a series of higher daily lows.

Is this sustainable?

The fundamentals, as outlined above, do not support a stronger Australian dollar. That is, all the fundamentals except one. Australia still enjoys a very favourable interest rate differential with all other major trading nations, including the USA. A Core interest rate of 2.5% is infinitely greater than the near zero rates that pertain elsewhere. This differential is of supreme interest to the institutions and hedge funds that engage in the Carry Trade, or the effective borrowing of funds in low-interest jurisdictions and its lending out in those countries where rates are high. Buying Australian government bonds is a good way to achieve this and to do so Aussie dollars must also be purchased. This tends to increase the exchange rate.

Core interest rates in Australia are so relatively high because the central bank is concerned about a residential property bubble, even while they would prefer a lower Aussie in order to help exporters. But now there are moves afoot to put regulations in place that would limit the banks’ ability to loan for property. Is this the forerunner of an eventual reduction in core rates that would make yesterday’s apparent upside breakout an also-ran?

There is also little doubt that general US dollar moves on the back of the imminent ending of Quantitative Easing (QE) is a factor here. The Federal Open Market Committee (FOMC) ends it two-day meeting today, after which its monetary policy statement will be issued. This will be closely watched.

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