Currencies | Dec 08 2010
The AUDUSD carved out a key reversal in November (higher high but closing below the prior high). In fact, price closed near its low for the month which reinforces the strength of the signal. Structurally, 5 waves up from the 2008 low warn of a multiyear correction back to at least 8065. A new high cannot be ruled out yet as price remains above a trendline on a weekly closing basis. A drop below 9535 would shift focus to 9405, 9220, and then 8860.
Substantial Australian interest rates have been a major driver behind AUD/USD strength, as speculators continue to sell the low-yielding US Dollar against the Aussie on the substantial rate differential. Overnight Index Swaps predict that the Aussie’s yield advantage will likely grow in the yield ahead—further improving the Australian Dollar’s attractiveness from an interest rate perspective. As far as yields are concerned, there are few currencies with the same prospects.
The more pressing issue is subsequently whether investors will continue to gravitate towards high-yielding carry trade currencies. As we have seen time and time again, the FX Carry Trade is a relatively ‘cowardly’ trading strategy. That is to say, traders are quick to flee carry trade longs at the first sign of financial market tensions. Assuming that risk sentiment remains buoyant, we might expect the Australian Dollar to remain strong against its low-yielding US namesake.
The Australian Dollar remains the most overvalued against its US counterpart, with spot trading at a whopping 30.3 percent premium to the PPP-implied “fair” exchange rate. AUDUSD remains firmly anchored to the MSCI World Stock index, hinting a deeper correction of the current disparity after a slight readjustment through November may be in the cards. Indeed, sentiment appears likely to succumb to lingering Euro Zone debt woes, an acceleration in monetary tightening in China, and profit taking in the aftermath of the Federal Reserve’s QE2 announcement that delivered an asset-buying program matching priced-in expectations, robbing a four-month surge in risk appetite built around bets on renewed stimulus of the impetus to continue.
What is Purchasing Power Parity?
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.
The views expressed are not FNArena's (see our disclaimer).
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