Aussie Dollar: Headwinds AheadAUD is a commodity currency. Australia’s resources rich economy is heavily influenced by commodity trade, particularly with China. When China sneezes, the AUD catches cold.
With the Reserve Bank of Australia (RBA)’s rate hiking cycle approaching an end plus China’s economic recovery remaining anaemic, the AUD is likely to weaken further in the short term.
This paper posits a short position in CME Micro AUD/USD futures to gain from a weakening Australian Dollar with an entry at 0.6584 combined with a target exit at 0.6300 hedged by a stop loss of 0.6747 delivering a reward to risk ratio of 1.75x.
RBA HAS PAUSED ITS INFLATION FIGHT
Fending off a stubborn inflationary environment, the RBA was quick to follow the Fed’s path in raising its lending rates to cool the economy. While not as aggressive as the Fed, the RBA held its rates at elevated levels.
Inflation in Australia has eased from its peak but hovers above those in the US. The RBA expects inflation to abate gradually to target levels of 2% by mid-2025.
With inflation trending lower and GDP softening, the RBA rate hiking cycle is likely at its apex. The RBA did not hike rates at its last two meetings. Much like other central banks, the RBA will be guided by macroeconomic data in shaping the path ahead for interest rates.
Thus far, economic data supports the case for no further rate hikes. Consumer spending and GDP growth has slowed over the last two quarters. Barring an unexpected reversal, the rates are at their peak. Sharp retail slowdown in June also vindicates RBA’s case for pause.
Still, the odds of further rate hikes are non-zero. The RBA has maintained a hawkish tone stating that further tightening may be warranted. Previously, even though RBA had opted for a pause in April, scorching inflation numbers forced the central bank to hike rates in May & June.
RBA’s next policy meeting is on September 5th and until then, the current bearish sentiment is likely to prevail. If RBA opts to continue with the rate pause, AUD is likely to weaken further.
US DEBT DOWNGRADES AND THE DOLLAR SMILE
Fitch, a leading ratings agency, recently downgraded US treasury debt. The downgrade has led to limited impact on treasury yields or the USD. Instead, the downgrade led to reduced appetite for risk assets and increased flow into the safety of the US Dollar.
This is the classic dollar smile phenomenon at play. The dollar smile helps explain the tendency of USD to shine when the US economy is not only strongly outperforming, but also when it faces turbulence.
This bodes negatively for the AUD which is a volatile currency as it takes cues from global commodities. Reduction in risk appetite leads to further weakening in the AUD.
UNDERWHELMING CHINESE ECONOMIC RECOVERY
China is Australia’s largest trading partner. Australia is a resource rich nation. Substantial portion of its resources are exported to China. Iron Ore, Copper, and Natural Gas top the list. Consequently, a slowdown in China adversely impacts the Australian Dollar.
China’s post-COVID recovery has been underwhelming. Growth is weaker than expected and domestic consumption remains fragile. Though there are signals that these may rebound, the process will be slow which suggests there will be limited demand from China for Australian commodities in the near term.
Inadequate Stimulus
China has not been able to rely on external demand for its goods to support its recovery. This has put further pressure on stimulating domestic demand.
Last week, Chinese officials announced stimulus measures which have fallen short of expectations. Officials have indicated further stimulus, but details remain scant and timeline vague. Given that, Chinese economic recovery is likely to be drawn out.
Feeble Manufacturing Activity
Manufacturing forms the backbone of the Chinese economy. Activity in the sector had been shrinking since February. However, the latest PMI data points to a slow reversal in this trend.
Inventory levels improved suggesting that de-stocking is ending. However, PMI at 49.3 still points to shrinking manufacturing activity which may take several months to recover as global demand remains pale.
OPTIONS MARKET SIGNALS SIGNIFICANT NEAR-TERM BEARISHNESS
Aggregate Put/Call ratio of CME Options on AUD futures stands at 1.74 indicating a clear bearish sentiment heavily weighted towards the front of the curve.
Analysing ratio across expiries, sentiment is overwhelmingly bearish in the near term with signs of bullishness in Q4.
Meanwhile, CFTC’s Commitment of Trader’s report shows that asset managers are positioned net short on the AUD and increased net short positioning by ~9000 contracts (~21%) last week.
Conversely, leveraged funds have switched their net short positioning to net long last week. Overall, COT points to a bearish sentiment.
TRADE SETUP
With Australian interest rates at their peak and Chinese economic recovery expected to be drawn out, investors can gain from the near-term weakening in the AUD using a short position in CME’s Micro AUD/USD futures expiring in September.
CME Micro AUD/USD Futures have a margin requirement of just USD 170 (as of August 7th) and provides exposure to 10,000 AUD. Every pip delivers a P&L of USD 1.
• Entry: 0.6584
• Target: 0.6300
• Stop Loss: 0.6747
• Profit at Target: USD 284 (284 pips * USD 1 = USD 284)
• Loss at Stop: USD 163 (163 pips * USD 1 = USD 163)
• Reward-to-Risk Ratio: 1.75x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
