Too hot Aussie leaves bears in the woods

The RBA, IMF and just about everyone else is tipping a lower Aussie dollar but you wouldn’t know it looking at recent price action.

Not even a sharp rise in the unemployment rate to six per cent could halt a recovery that has seen it gain three cents, or 4.6 per cent, in the last few weeks. So why is the Australian dollar so strong at the moment? There are a few key reasons I can put my finger on.

The first one is higher inflation which has, in part, caused the RBA to shift its monetary policy setting from easy to neutral. At the same time, we have seen some weaker-than-expected US economic data put downward pressure on the Greenback, thereby supporting the Aussie. If we add to that some positive signs relating to credit growth out of China, it seems there is some ammunition for further gains.

With the market still bearish on the currency, and generally positioned this way, there is room for a little more upside in the short term. The 91-cent level might be hard to break and if it does we could see further gains towards 93 cents, but I suspect this would be short lived.

There are several reasons why I think this trend will eventually reverse - and the first sign of this might be seen this week. Apart from higher local inflation, the positive sentiment coming from the other two drivers I mentioned above - a weaker US dollar and positive China data - could reverse quite soon.

To begin with we have the Producer Price Index out of the US, which measures change in the price of finished goods and services sold by producers and is a leading indicator of consumer inflation. The market is expecting a better result than the previous month's 0.4 per cent rise, with an increase of 0.6 per cent forecast. The timing of this report is important as it comes less than 24 hours before the US CPI (consumer price index) report and the release of the US Federal Reserve Bank meeting minutes.

I suspect the recent focus on weather-affected economic data in the US will shift back to the possibility of higher inflation and confirmation of further tapering by Fed officials. These factors would support gains in the Greenback and weigh on the Aussie.

In addition we also have HSBC Flash Manufacturing PMI for China out this week, with further falls likely. This would also weigh on the Aussie dollar.

When balancing the recent positive sentiment with the risks posed through this week's data, I suspect the Australian dollar may just remain around the 90 cent handle (give or take a few cents) for quite a while to come.

Any major weakness towards sub 85 cents, should it eventuate, is more likely to come in the second half of the year.

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".