The dollar’s medium-term comfort zone

The Australian dollar is likely to remain in a narrow trading range … until central banks move to normalise interest rates.

Summary: Foreign exchange traders have cut back on buying the Australian dollar, but there hasn’t been a commensurate increase in selling contracts. This suggests the market was never really bearish on the $A, just not as bullish.

Key take-out: The Australian dollar is likely to fall sharply once central banks cut back on their Quantitative Easing programs and then hike interest rates. But that won’t happen anytime soon.

Key beneficiaries: General investors. Category: Portfolio management.

For much of this year the $A was on a downward trajectory, coming off from over $1.05 at the beginning of the year to about 1.0360 now.

Indeed, prior to the recent employment numbers, most folk had been talking about further near-term falls in the $A – perhaps even to below parity. This was something that did actually appear to be borne out by the change in speculative trading positions. Take a look at Chart 1.

Chart 1 shows the net long positions of traders (long equals a trader buying the $A and short equals them selling. The net position is longs less shorts) mapped against the $A. It’s a pretty good correlation and, the thing is, it shows the number of net longs has fallen sharply since a peak late last year and early this year.

Having said that, the fact that net longs are down doesn’t by itself tell us about the future direction of the currency and it’s not the first time net long positions have declined. It was only mid last year the market was short – the currency meanwhile ended up pushing higher.

We can, however, learn two things from this data. Firstly, the market wasn’t actually short $As, that is traders weren’t net sellers. Chart 2 shows this more clearly.

You can see from the chart that it’s not so much that people were short the $A this year, although the number of short positions is higher. It’s more the case that longs have dropped off – or the numbers of buyers fell off. The number of contracts has fallen by over 60% since the high reached in December and January. If the market had really changed its view and thought the $A was heading lower, you’d see a lot more of those longs go short – some have, but by and large that hasn’t happened. That the drop-off in buyers occurred without a commensurate lift in shorts is telling. It suggests that the market was never really bearish on the $A, just not as bullish.

Cue recent developments – the surge in domestic equities, rising house prices, auction clearance rates and the lift in jobs. These eventualities make it much less likely that we’ll see a near-term easing by the RBA. Some suggest the easing cycle may be over. Consequently, the fear now is that the $A will rise and this will do all manner of terrible things – crunch the economy, and maybe smash the All Ords. Note though that even after the strong jobs report, the market has been slow to extend longs – it’s been marginal. The unit itself is only up a bit and still a couple of cents off its January high. For that reason, I don’t think scaremongering over the $A is the right way to think.

Look again at chart 2. Longs started being taken in late last year and that process accelerated early this year. The thing is, we knew back in January, even late last year, that the easing cycle was drawing to a close. Most analysts at that point only factored maybe one or two cuts at best. Similarly the equity market was already rallying hard, US markets were approaching new highs, iron ore prices rebounded, and we didn’t go over the fiscal cliff. That’s not to forget the fact that domestic jobs outcomes were already much better than feared – in particular, the unemployment rate, having been forecast to be around 6% by now, actually ended the year at 5.3%.

And yet long positions were still reduced sharply – especially from 2013.

This is crucial because it tells us that domestic factors/perceptions of the RBA weren’t, and still aren’t, the primary consideration for traders in reducing their long positions. That means that global considerations were the key swing factor. Effectively the $A weakened, despite all the bullish news flow, because US growth prospects were proving to be much brighter, as were China’s and Europe’s (notwithstanding this latest Cyprus hiccup). That’s not to say domestic news is irrelevant. It isn’t, but it’s an overlay. Not a strategic or directional game changer.

With all that in mind I think the best bet on the $A is continued near-term range trading, at above parity. Longer-term I still think the $A will head lower, much lower, but not yet. We need to see the Fed cut back on Quantitative Easing, even end it, and then hike rates. I don’t think it will do that soon though – but make no mistake, the day will come when central banks around the world have to normalise rates. The $A will be much weaker then.

As for those upside risks. Well here again, while the Aussie news flow is getting better, so is the US economic news flow and the global flow more generally. Even the OECD said the outlook is much brighter. That should keep a lid on the $A. Similarly, while people may talk about the end of the RBA’s easing cycle, I’m not so convinced. Don’t get me wrong, I think rates should be higher. But we’ve already had an RBA official, assistant governor Christopher Kent, come out and downplay the strong jobs figures. This is despite it being the sixth month out of eight that we saw decent jobs gains – and despite the fact the unemployment rate hasn’t risen as the bank expected.

So it won’t take the RBA much to cut and it will certainly not entertain the notion of a rate hike soon. This just isn’t on its agenda – the RBA has said this as it thinks low rates are appropriate – and we shouldn’t forget the pressure it is still under, even from within the board, to lower the $A.

The bottom line then is that I don’t think we’ll see, out of any influences that have emerged, something with sufficient strength to change the broad momentum of the market. Traders seem to agree.

Effectively, the $A has been range-trading for about two years – the lines of resistance or support may vary slightly on the circumstance, but chart 3 is pretty clear. At the moment, support seems to be just below 1.03 with resistance around 1.07. That may change, depending on what the nuances the Fed and RBA come up with – but the $A will trade within a range and I don’t think will change that for now.

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