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Is Today the Start of a Major Australian Dollar Bounce?

By , Quantitative Strategist
11 June 2013 17:20 GMT

Summary: Why is the Australian Dollar so weak, and could its very recent bounce be the start of a larger bounce? We think so, and here’s why.

The Australian Dollar trades at multi-year lows as the second-worst performing G10 currency year-to date, but markets can only move in one direction in so longwhy might it bounce?

Several weeks ago I wrote that sharp AUD declines might have actually been the “Canary in the Coal Mine” for the S&P 500. In other words: sharp Australian Dollar declines pointed to similar weakness in stocks and broader financial markets. Frankly I’d rather be lucky than good, but the S&P 500 set an important top the very next day. What now?

Stocks seem to have stabilized somewhat after the S&P posted two consecutive weeks of declines, and indeed our short-term technical forecast suggests the index might continue to hold key lows. Could this point to an Australian Dollar bounce? Maybe, but first we a key driver of Aussie weakness—speculative trades.

The chart below shows that Australian Dollar positioning is at its most extreme on record—futures speculators are extremely net-short, while commercial hedgers are at their most defensively long in history.

Australian Dollar Futures Positioning at Record Extremes

forex_sentiment_favors_australian_dollar_bounce_heres_why_body_Picture_1.png, Is Today the Start of a Major Australian Dollar Bounce?

Data source: CFTC Commitment of Traders Report, Chart Source: R

As our Senior Technical Strategist wrote yesterday, such extremely one-sided Australian Dollar positioning warns of reversal. All the while, our retail forex trader sample shows similar positioning extremes:

Retail Forex Speculators are Extremely Long the Australian Dollar

forex_sentiment_favors_australian_dollar_bounce_heres_why_body_Picture_2.png, Is Today the Start of a Major Australian Dollar Bounce?

Data source: FXCM Execution Desk, Weekly Sentiment Table

I wrote on Thursday that retail positioning warned of a potential AUDUSD bounce, but it was too early to try and pick a bottom. Just as well—it continued onto fresh lows.

But nothing moves in a straight line, and positioning is far too one-sided in our opinion for the sell-off to continue. We’re likewise seeing signs of popular sentiment extremes as reputable newspapers use headlines such as “Australian Dollar plummets” to describe recent price action.

I can see the counterargument now—“but won’t Reserve Bank of Australia interest rate cuts and falling gold prices continue to hurt the Aussie?”

That’s certainly possible, but our Senior Currency Strategist favors a near-term low in Gold prices. All the while, the Australian Dollar/US Dollar interest rate differential itself is at risk of pullback.

I’ll be the first to admit that it’s dangerous to try and buy into such sharp declines, and indeed our sentiment-based trading strategies have done well in selling into Australian Dollar weakness. In fact, our volatility-friendly Breakout2 system is currently short the Australian Dollar against the US Dollar, Japanese Yen, and Euro.

I further wrote on Monday that breakout trading remained attractive on the AUDUSD, EURAUD, and AUDJPY. So clearly this is somewhat of a departure from what I’ve recently said.

Yet there are too many signs of a potential sentiment and price extreme to ignore—I would avoid selling the Australian Dollar at current levels and will look to buy against recent lows.

Summary of Positions in DailyFX PLUS Trading Signals

forex_sentiment_favors_australian_dollar_bounce_heres_why_body_Picture_3.png, Is Today the Start of a Major Australian Dollar Bounce?

Source: DailyFX PLUS Classic Trading Signals

Forex Correlations Summary

View forex correlations to the S&P 500, S&P Volatility Index (VIX), Crude Oil Futures prices, US 2-Year Treasury Yields, and Spot Gold prices.

forex_sentiment_favors_australian_dollar_bounce_heres_why_body_Picture_4.png, Is Today the Start of a Major Australian Dollar Bounce?

Data source: Bloomberg. Chart source: R

SEE GUIDE ON READING THE ABOVE CHART

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

Receive future special reports on the Australian Dollar and other studies via this author’s e-mail distribution list with this link.

David specializes in automated trading strategies. Find out more about our automated sentiment-based strategies on DailyFX PLUS.

Contact and follow David via Twitter: https://twitter.com/DRodriguezFX

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11 June 2013 17:20 GMT