Rates, risk and Aussie dollar defiance

It has been interesting to see the Aussie dollar bounce back from last week’s low to trade back at US94c, despite talk of a sooner-than-expected US interest rate rise and risk aversion plaguing currency markets. The Aussie dollar was seemingly facing some very stiff resistance late last week, but subsequent price action suggests to me a retest of US95c could be just around the corner.

There are a few signs that the Aussie is positioning for more of a squeeze higher. We have a combination of a higher greenback due to Yellen's comments and risk aversion, plus the markets ignored strong Chinese GDP to push the Aussie dollar lower. Traders are also somewhat complacent with the Reserve Bank and domestic inflationary pressures which could come back to bite this week.

Is this indicative of a market overreaction?

I think the markets may have overreacted to Yellen’s comments about potential interest rate rises coming sooner than the markets currently anticipate. Traders that have been backing this view would be desperate for the Fed to start positioning the market for a rise as soon as possible.

While it is likely this will happen eventually, it may be some time off and we could get confirmation as such from this week’s US inflation report. Softer CPI stateside would underpin the need to maintain expansionary monetary policy, and if June inflation does show a decline this would serve to weaken the greenback. Look out for dovish comments from Yellen.

The devastating tragedy of flight MH17 sent financial markets into a spin late last week and in what has become somewhat of a typical reaction, the US dollar and Japanese yen -- supposed safe havens of the currency world -- rallied. We have already seen this start to unwind and although there is likely to continue to be political tension in play, the currency markets may soon start to ignore further developments and focus on the fundamentals.

Closer to home we have RBA Governor Glenn Stevens and his assistant Guy Debelle both speaking this week. While they are expected to reiterate that interest rates are on hold for the foreseeable future it will be interesting to see if they provide any comment on the currency. Whether they take the opportunity to talk the dollar down or not, I still expect the Aussie to trade higher as recent jawboning is having limited affect.

More pressing for the markets may be Wednesday’s second-quarter Australian inflation report. Although the Reserve Bank seems comfortable with inflation remaining within the 2-3 per cent range, a higher than expected quarterly trimmed mean at 0.8 per cent or higher is likely to see some adjustment to expectations on the cash rate and also add support to the Aussie dollar.

Whilst the Aussie dollar has been contained within its US93-95 cent range, the release of respective inflation reports may start to move bond markets this week and take the currency with it, especially if they move in different directions, i.e. US CPI lower and Australian higher.

Jim Vrondas is Chief Currency strategist, Asia-Pacific at OzForex, a global provider of online international payment services and a key provider of Forex news. OzForex Group Limited, is a publicly listed entity with shares traded on the Australian Securities Exchange under the code "OFX".