The Second-Chance Aussie Trade in Play Now

Kathy Lien

After last night’s rate cut and decisive comments from the Reserve Bank of Australia (RBA), the AUDUSD is falling sharply, but traders still have room to capitalize on an increasingly likely move to parity.

On the heels of an extremely busy night in Australia, the Australian dollar (AUD) will be especially in play. We start the day off with the country's PMI construction report, which was to be followed by the trade balance and house price index. While the housing market most likely saw steady growth in the first quarter, trade and construction-sector activity should have suffered from weaker economic activity.

However, disappointing economic data will not move the AUD much ahead of the main event: the Reserve Bank of Australia (RBA) monetary policy decision.

The consensus forecast was for steady rates, but investors were pricing in a 55% chance of a rate cut, and they weren’t disappointed, as the RBA lowered its benchmark rate to a record low at today's meeting, driving AUDUSD below the 1.0200 level in what was otherwise a very uneventful session in the currency market.

The RBA cut the interest rate another 25 basis points (bps) to 2.75%, citing slowing growth in the global economy and leaving open the possibility that the central bank may lower rates further before year end.

In the statement by RBA Governor Glenn Stevens, he noted that, "Growth in Australia was close to trend in 2012 overall, but was a bit below trend in the second half of the year, and this appears to have continued into 2013. Employment has continued to grow but more slowly than the labour force, so the rate of unemployment has increased a little, though it remains relatively low.”

Stevens went on to say “With the peak in the level of resources sector investment likely to occur this year, there is scope for other areas of demand to grow more strongly over the next couple of years. There has been a strengthening in consumption and a modest firming in dwelling investment, and prospects are for some increase in business investment outside the resources sector over the next year. Exports of raw materials are increasing as increased capacity comes on stream. These developments, some of which have been assisted by the reductions in interest rates that began 18 months ago, will all be helpful in sustaining growth."

Governor Stevens made particular mention of the exchange rate, stating that it "has been little-changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates during that time. Moreover, the demand for credit remains, at this point, relatively subdued."

This was a clear signal by the central bank that it views the AUDUSD as being too high at current rates and would like to see the pair trade lower—at least below parity—in order to rebalance the economy and stimulate the export sector.

To drive its point home, the RBA stated that, "The Board has previously noted that the inflation outlook would afford scope to ease further, should that be necessary to support demand. At today's meeting, the Board decided to use some of that scope."

The emphasis on the word “some” suggests that the RBA is not finished easing just yet, and given the absence of any price pressures in the Australian economy, the Bank would not hesitate to cut rates to 2.5% before year end.

The AUD initially tumbled on the news, dropping below the 1.0200 level, but later found some support from reported Asian Central Bank buyers who were bargain hunting the pair. However, as the day progresses, the downward pressure on the aussie is likely to increase as markets fully digest today's message from the RBA.

With global growth clearly slowing, especially in its key export market of China, the RBA is now seriously focused on lowering the exchange rate for the pair. For now, the AUDUSD enjoys long-term support at 1.0150, but if tonight's report confirms the slowdown in economic activity, the pair could very quickly fall towards the key parity level as the week progresses.

When it comes to the Australian dollar, after the initial knee-jerk move, there tends to be a period of consolidation and sometimes even a short-term reversal during late-Asian trading. This allows traders to catch the move in the direction of the event risk surprise for a continuation of the knee-jerk reaction during European and North American hours.

The reason why this opportunity exists is because there is less liquidity in Asia, and when Europe joins the fray, traders take a look at overnight developments and respond more aggressively.

Euro Falls on Talk of More ECB Easing

The euro (EUR) came under selling pressure on Monday after European Central Bank (ECB) President Mario Draghi made it clear that the Bank is prepared to ease again if economic data worsens.

At the end of last week, conflicting comments from European policymakers created some confusion in the markets. Some members of the central bank said investors may have over-interpreted Draghi's comments about keeping an open mind about negative deposit rates, and clearly, Draghi wanted to make sure the market understood that he stands behind his commitment to increase stimulus if necessary.

While we believe the bar for negative deposit rates is high, the main takeaway from Draghi's comment and ECB policymaker Ewald Nowotny's retraction on Friday is that the central bank wants everyone to know that they have a bias to ease and won’t hesitate to take action if economic data continues to worsen.

Thankfully, Monday's Eurozone economic reports were better than expected, with service sector activity numbers revised higher. Eurozone retail sales continued to decline in March, but the pace of the decline has slowed.

German factory orders are scheduled for release on Tuesday, however, and given the recent disappointment in the PMI manufacturing report, we are weary that orders will decline by a larger amount in March.

Overall, we believe that the EURUSD is headed lower. The 1.30 level may appear to be rock-solid support right now, but between the ECB's bias to ease and the risk of more disappointments in the coming month, it should only be a matter of time before this level is broken.

Dollar Extends Gains as Stocks Hit New Highs

While there was no US data on the economic calendar on Monday, the US dollar (USD) traded lower against all major currencies. The optimism from Friday's non-farm payrolls (NFP) report continued to affect currency and equity flows, and US stocks climbed to fresh record highs while the dollar extended its gains against the Japanese yen (JPY).

Friday's rally in risk currencies should have also been sustained, but comments from ECB President Draghi and the disappointments in Chinese and Australian economic data deterred demand for the euro and aussie.

In the long run, improvements in the US economy should support growth in other countries, but right now, we are still in an environment where some countries are enjoying healthier growth and others are falling victim to deeper recessions. As a result, country-specific factors are having a more significant impact on FX flows than risk-on/risk-off sentiment shifts.

For the dollar in particular, this means that the recent data improvements and optimism from the Federal Reserve should keep the greenback more attractive relative to other currencies. Tuesday should be another quiet day for the US dollar since no major US data is scheduled for release.

See also: A US Dollar Correlation Not Seen in 5 Years

Traders need to keep an eye on US stocks and Treasury yields, however, because further gains in equities and continued rallies in Treasury yields could drive USDJPY closer to 100.

British Pound (GBP) Stuck at 1.56…For Now

It was a mixed day for the British pound (GBP), which traded slightly lower against the US dollar and slightly higher against the euro. With European Central Bank officials taking every opportunity to remind investors that they stand prepared to do more, the UK's steady monetary policy is expected to boost the attractiveness of sterling.

No UK economic data was released on Monday, but last week, we learned that manufacturing, service, and construction sector activity improved, allowing the Bank of England (BoE) to breathe a sigh of relief.

The BoE meets this week and is widely expected to leave monetary policy unchanged. For the most part, the stronger PMIs point to potential upside surprises in UK data this week.

Meanwhile, the 1.56 level continues to be key resistance for GBPUSD, and given recent economic surprises, we are looking for an eventual break which could accelerate a move up to 1.58.

USD/JPY Set to Test 100 Again

The Japanese yen (JPY) traded lower against most major currencies on Monday even though Japanese markets were closed for a holiday. The extension in US equities helped to sustain the risk-on mood in currencies, which lent support to the yen crosses.

There was no Japanese or US data released, but many traders have their eye on USDJPY, which is once again inching its way towards 100.

While we believe that a break of 100 for USDJPY is ultimately inevitable, and given the current proximity to this level, a test is possible, we are skeptical about whether a sustained break can occur this week.

See related: USD/JPY Has One More Reason to Rally

By Kathy Lien and Boris Schlossberg of BK Asset Management

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