The Aussie Dollar as a Measure of Global Risk Appetite

Has the Aussie dollar finished crashing? Its plunge is a direct consequence of the global aversion to risk as credit markets implode and governments scramble to hold the system together. So what is the Aussie telling is about the current global appetite for riskier assets?

Well first, you already know the Aussie Dollar has plunged against the US Dollar since mid-July. But you might be surprised to know it-s also declined against all the other currencies of the G10. This is because it is a commodity-related currency. The sell-off in the commodities market as well as the decline of the local equity markets have been part of the sharp pull-back that began in July.

The other driver has been interest rates. The RBA cut rates in September and October by a combined 125 basis points. These rate cuts decrease the upside potential of the Aussie. The currency was strong in the last few years because of the interest rate spread and of course, booming commodity prices.

First, take a look at a weekly chart below. The beginning point of the recent multi-year rally was in 2001 (point A on the chart). At this time the AUD/USD currency pair was trading around 0.51. It rose until 0.9849 in July this year. The pair nearly doubled in seven years.

The trend was so strong it overcame all resistance. The first main resistance to this long-term bullish trend was 0.80 (points B, C and D). That level became a new support level (points E and F) once it was broken through. The recent strong bearish move easily cleared this level. It has now found new support around 0.6350 (point G), which was a previous low posted in 2003 (point H).

In terms of percentages, the fall is impressive. Between the closing price of July 15th, which is the historical high price, and the closing low posted last Friday, the Aussie lost more a third of its value against the USD. It-s a decline of exactly 34.3% in less than 3 months (between points A and B on the daily chart). That is exceptionally rare on the FX markets.

As a result, the technical indicators have moved down into deeply oversold territory. However the recent (temporary?) bottom and the bounce back initiated this week argue for a further rebound.

The 14-day Relative Strength Index (RSI) has just triggered a bullish signal as it curved upward and left the oversold area by crossing above it signal line. It also shows a bullish divergence. A bullish divergence occurs when the market price is making a new low but the RSI is failing to do the same: the RSI does not confirm the new low. This divergence is an indication of an impending reversal.

This bullish divergence is confirmed by another oscillator with longer-term parameters, the 100-day Commodity Channel Index (CCI). Other indicators show that some further positive price action is likely.

In this scenario, a significant correction of the recent decline is expected. The Fibonacci retracement levels of the 3-month plunge give us the next targets for the coming rebound. The levels of 0.72 and 0.77 are consequently the objective prices as they correspond to the first two ratios (23.6% and 38.2%).

Whether the rally in the Aussie signals a new appetite for global risk taking remains to be seen. In the past five years, foreign investors have been fond of borrowing in dollars and yen to buy Australia-s currency and its commodity stocks. With the prospects of a global recession in 2009, this carry trade may not recover its previous popularity.

That should make for much more volatility in individual Aussie resource shares. These shares will now be valued on the basis of their individual prospects and the forecasts for commodity prices in general. You can expect a divergence in resource shares between those that went up strictly because of a rising market, and those that have good projects that will generate real earnings in the next year.

As always, this volatility is excellent for traders. And as chartists, we believe the fundamental value in excellent resource companies will show up on the charts too. Our momentum indicators are designed to identify these stocks once their moves begin. It won-t be the whole market. But it doesn-t have to be to still be lucrative.

Gabriel Andre
for The Daily Reckoning Australia

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