Forex_Australian_Dollar_May_Find_Fuel_for_Recovery_in_Bond_Yield_Shift_body_Picture_5.png, Australian Dollar May Find Fuel for Recovery in Bond Yield Shift

Fundamental Forecast for Australian Dollar: Neutral

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The Australian Dollar faced renewed selling pressure last week, touching the lowest level in close to three years against its US namesake, after the Federal Reserve monetary policy announcement added fuel to speculation about a cutback in asset purchases emerging on the horizon. This sparked a widespread reversal in trends dependent on the presumption of continued Fed money-printing, sending the US Dollar broadly higher against the majors as dilution fears unraveled.

Continued re-pricing of Fed policy expectations in the week ahead need not necessarily translate into Aussie weakness. The post-FOMC environment featured an aggressive unwinding of the “Fed levitation” trade, whereby investors exited positions in risky and higher-yielding assets that relied on cheap QE-based funding. This sent Australian government bonds sharply lower, pushing the 10-year note to a 14-month low. US Treasuries likewise tumbled as markets began to bake in the exit of a key buyer responsible for absorbing $85 billion in supply every month.

Australian and US yields both jumped higher as bond prices fell but the move was more pronounced in less-liquid Aussie paper, forcing a divergence between AUD/USD and the front-end yield spread. This shift in the relative rate of return in favor of the Australian unit comes against the backdrop of another record on speculative net-short positioning. This may have made the market somewhat more sensitive to counter-trend developments as investors sitting on short positions become prone to profit-taking. In this context, the move higher in the yield spread can be a potent upside catalyst for AUD/USD as it becomes increasingly expensive to remain short, forcing a correction of recent weakness.

With that in mind, a countervailing consideration is the possibility that Fed-linked liquidation matures to broader-based risk aversion. As we discussed last week, the coupling of equity and fixed income markets as well as a lack of participation from the Yen-funded carry trade amid the post-FOMC carnage hints it was not a pure collapse in sentiment. Threats to global growth courtesy of sticky recession in Europe and an emerging credit crunch in China may yet produce wider erosion in confidence, a scenario that is likely to weigh heavily on the risk-geared Aussie.