Australian Dollar Faces Near-Term Pressure

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Mark McCormick

NEW YORK ( BBH FX Strategy) -- The Australian dollar (AUD) has been among the top performers in the G10 since market sentiment bottomed out in late September. The strength has caused the currency to test its 200-day moving of 1.0383 (U.S.) dollars.

In our view, this sharp move was a function of multiple factors including: 1) increasing optimism over Europe; 2) better-than-expected U.S. data; 3) a significant accumulation of net-long USD amid a sharp adjustment in speculative positioning; 4) hopes that China avoids a hard landing; and 5) Australian domestic economic data.

However, we suspect that the AUD is likely to remain under pressure in the near term as coming eurozone policy meetings are likely to weigh on risk appetite.

We remain constructive of the Australian dollar/dollar currency pair (AUD/USD) in the medium term because of our baseline expectation that China avoids a policy mistake and a hard landing. But we see immediate downside risks to the AUD/USD because of the elevated uncertainty ahead of the European events in the coming weeks and the extended short-term positioning.

Taken together, this may lead the AUD to pare back some of its recent gains with the 20-day moving average (0.988) likely the next major level of support.

In particular, short-term positioning data and technical indicators show that the AUD/USD is likely overextended (see chart).

We suspect at this juncture support from positioning may run out of steam as investors take a step back ahead of important European policy events over the coming weeks.

On a valuation basis the AUD/USD looks more expensive than any other currency in the G10, given its relative distance from short-term moving averages.

Currently, spot is nearly 4% higher than its 20-day moving average, which is nearly double that of any other currency in the G10, suggesting the AUD/USD may be less attractive if risk appetite continues to falter from here.

What's more, options prices look extreme, with one- and three-month risk reversals both one standard deviation from their monthly average (see chart).

Notwithstanding the sharp swings in market sentiment, domestic economic data and the outlook for policy are likely to remain a key driver of the AUD in the medium term.

With recent employment figures surprising to the upside and economic data surprises overall remaining firm, we suspect that the 100 basis points of cuts priced into the policy over the next year is too aggressive.

In fact, Australian economic data have recently exceeded market expectations by nearly one standard deviation, adding further evidence that the outlook for rates is too dovish.

Rather, our takeaway from Monday's Reserve Bank of Australia minutes suggests scope for policy action is conditional upon a sharp deterioration in the global backdrop. As such, we continue to expect the RBA to remain on hold.

Still, looking ahead, Australia's current account deficit and openness to trade leave the AUD sensitive to shifts in global sentiment in the near term. Indeed, the current account deficit of nearly 2.4% of GDP is among the widest in the G10. That leaves Australia exposed to a softening of capital inflows (or even downright outflows), highlighted by the nation's deteriorating capital imports.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.