MARKETS SPECTATOR: Watch out for a dollar dive

You don't have to look far before you see reference to the strength of the Australian dollar and the impact it's having on our economy.

Despite the 175 basis points of interest rate cuts over the last year, the Australian dollar has continued to remain stubbornly high due to demand for Australia's AAA-rated bonds, its yield advantage over nearly all other developed nations and demand for the Australian dollar as a reserve currency.

Most recently, as you can see below the AUDUSD has broken up through the support (was resistance) level and had a tilt at the 1.06 level overnight. However, during the overnight session there was a significant rejection of higher prices, resulting in a move back towards the 1.0550 level.

Source – Iress

The trademark sign of big price rejections is what technical analysts call ‘long shadows', which can occur in both directions. On the above chart, long upper shadows (orange circles) mark trading sessions where prices have tried to move sharply higher, only to be overcome by a large amount of selling that sees prices reverse lower.

So judging by what happened overnight, there looks to be a lot of willing sellers up around the 1.0580-1.06 level. This indicates that we're likely to see some sort of pullback in the short-term, perhaps to around the 1.0480-1.05 support level before the buyers look to push it higher again.

While there's little doubt that the path of least resistance is higher in the medium term, I'm nowhere near as bullish as many people are. In fact, the contrarian in me is watching for signs of weakness in the coming months as my gut instinct tells me a great short trade may not be too far away.

Some of the reasons behind my thinking include

– This is a very crowded trade. In data released last week from the Commodity Futures Trading Commission, it showed that the net long futures position in the Australian dollar was at a record high of 92,229 futures contracts. This marked the fastest turnaround on record as the futures traders were net short 51,172 contracts in June 2012. This sort of data leaves me wondering ‘who is left to buy'?

– Since the last interest rate cut, the Australian dollar has rallied approximately 1 cent. This has sparked a barrage of opinion suggesting fiscal policy no longer works and that there is no way for Australia to lower its currency. It's this extreme sentiment where people seem to ‘give up' that has caught my attention.

– Right now, no one can see a potential trigger to an Australian dollar sell off. Everyone thinks it's going higher. This is a classic example of the psychology involved with market tops and bottoms. Participants are always the most bullish at the top and the most bearish at market bottoms. The market simply gets so bullish that there are, figuratively speaking, no more buyers left.

Having outlined all this, it now comes down to timing, which is the difficult part. This could play out early next year or in two years' time; it's simply too hard to tell at the moment. There could even be a move higher to test the 1.10 mark again before a sell off occurs.

We'll need to be patient and wait for price action to turn bearish before looking to capitalise on what could be a fast and furious sell off.