Where once China exported deflation to the globe as its workforce migrated to the cities and competed with the developed world in manufacturing, now this burgeoning urbanised population requires accommodation, roads and railways. China is competing with Australians for their own natural resources – and so prices must climb higher. This is the logic that underpins the huge investments currently being made to extract yet more resources out of the earth at an even faster pace. (Whether this logic has been perverted by capital markets is an argument for another time.)

One of the prices that has climbed higher has been the Australian dollar relative to just about everything. We’ve argued for a couple of months now that this year’s spike has taken the currency beyond the realms of reasonable – that the extrapolation of China’s implied thirst for resources was excessive given the risks to it’s growth model. So to the latest “Cost of Living” survey by Mercer (here) that identifies the world’s most expensive cities – Australia gets a special mention:

And the primary reason (it wasn’t because house prices went up or the cost of consumables climbed faster than our international peers):

All six cities jumped at least 10 places between their 2010 ranking and their 2011 ranking – and two, Canberra and Adelaide, jumped 40 or more positions. This movement is due primarily to the recent strength of the Australian dollar, which appreciated by almost 14% against the US dollar over the 12 months considered. Consequently, a New York City assignee would need more US dollars to purchase a similar basket of goods and services in Australia, and the Australian cities’ rankings all went up.

We may yet see a thrust of Chinese national hubris that will take commodity linked prices to as yet unseen peaks, but I’m confident that history will view the current period as an aberration rather than the status quo.

All things considered, it has held up remarkably well. From all reports, its been central bank buying that has provided the support – everyone from the Chinese, to the Middle East, to South America, to Eastern Europe have been said to be on the bid.

The question then is who has been doing the selling?

One answer is hedge funds that have been taking advantage of the relative strength to exit long positions. We can see that open interest on the Aussie dollar futures contract has fallen back from its highs:

And that its been the leveraged accounts that have been closing out positions:

Historically, hedge funds have a reasonable track record in anticipating the changes in currents in foreign exchange markets. Hence the weakness in the money flow index as derived off the futures markets bears watching.

Still there’s no denying a central bank with a large cash balance if they have a mind to buy a currency whatever the price – barring a full blown currency crisis Bank of England 1992 style. Couple this with the anticipated inflows that are expected to support the capital spending commitments over the next 12 months and you can make a pretty convincing case for the Aussie dollar to revisit its highs. It could even break to news highs if a global government of substance decided to get the cheque book out again.

Without additional government stimulus however I remain positioned for more downside. Risk markets are showing a distinct unwillingness to embrace a world without monetary support. If the central bank bid were to step back, then I think we can expect a stop loss frenzy on a break of 1.0475.

Sentiment for the risk trade has soured significantly since the start of the month and looks like it will struggle to regain its footing from here without some additional governmental stimulus. But even before this most recent selling, the strength of bullish conviction was fading. We had some further confirmation of this today when the RBA released the latest Australian dollar turnover stats for April.

In the top chart we can see that trading volumes subsided once again in April. If the Aussie bull had been embracing the breakout in prices, volumes should have risen. We can see this effect more clearly in the Money Flow index that blends the relative strength index (a measure of price momentum) with volume. The lower high in this index, as the AUDUSD was charging to its heights, is a clear non-confirmation of the move.

But events have moved on, the AUD has pulled back – so where to from here? Here’s a couple of things to consider:

1) At levels around AUDUSD $1.05 there remains plenty of downside. Based on how extended it is relative to it’s longer term moving average – it could revert all the way back to ~0.95 without threatening the uptrend.

2) Global risk markets are in retreat. The new downtrend is unlikely to be smooth – and weak shorts are likely to be stopped out by seemingly schizophrenic swings between hope and gloom. Gloom that US growth may stall, that China faces a hard landing and that Europe will simply tear itself apart. Hope that the at least one, and maybe a consortium, of governments will step in and stop the rot.

Conclusion - My view is that until the stimulus arrives, the markets are likely to keep stepping lower. It’s really a price discovery process. The worse things get, the more likely some government with a big blank cheque will be looking for a pen. The question we are all trying to solve is exactly how far do we need step over this cliff before the stimulati blink. We remain short the AUDUSD with a three to six month horizon.

Okay, what’s the relevance? It’s that a weekly close tonight in New York could provide a relatively rare event – a key reversal. That’s where the price made a new high during the week (1.1012 – according to FXStreet.com), but closed below the low of last week (1.0677). From memory, it’s a relatively reliable signal for a change in trend. Now if only I had access to the world of data I could test the theory.

But first, over to our New York desk for the setting of the closing weekly price.

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Postscript – Stockcharts blog (here) notes that the SPY is on at risk of a marking out a Weekly Bearish Engulfing Pattern.

Quickfire movements such as we have seen are uncommon enough events, though the most recent decade seems to have had its fair share. The last time that the Aussie was able to sustain this type of move without at least a reflexive correction was in the 70′s and the world was a very different place then…

Or was it? After Nixon ripped the USD from the last vestiges of gold convertibility in 1971 (some background here), the USD was pummeled relentlessly.

And in real terms

Now we are faced with a similiar dynamic. Whatever the why’s and wherefore’s, the USD has few friends. Expectations of its imminent demise are widely held.  Short positions dominate. Ultimately, consensus is its own worst enemy – the weak side becomes the counter-trend trade. But that is what drives a market correction not a change in trend. Looking at history, the USD could have a year or three of heavy weather before the trend is exhausted.

Still with the Aussie overbought, and overvalued by ~40% on PPP measures, we should pay attention to the breadth measures that are suggesting that volume continues to undermine this latest rally.

With the domestic economy having all the bouyancy of overripe cheese, I remain of the view that the AUSDUSD is at risk of a material correction on a global tightening of liquidity (as QE2 fades into the distance and China continues its tightening ways – note there is risk to this view as Japan has kicked it monetary stimulus machine back into gear). If the Aussie signals technical weakness, I expect to add to our short AUDUSD position (here).

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For clarity, the short AUDUSD position is part of a portfolio that includes long gold and oil positions (that generally benefit from weakness in the USD).  Also, as an Australian based investor, my equity portfolio is natively long Australian dollars.

Having said all this – it is what it is – a short AUDUSD position. And well out of the money at an exchange rate of 1.09…

3May10 - Added to the short position after the dollar reversed off 1.10. With weakness in copper, gold and equities starting to creep in – there is gathering momentum for a USD rally and risk selloff.

Open interest on the CME also suggests that hedge funds and the like have been jumping onto the long commodities / short USD view once more – the market is overweight this trade and increasingly exposed to a reversal in flows.

In this context, it’s notable that the futures market is also showing signs of exhaustion as the Money Flow Index – that combines RSI with volume – continues to mark out a series of lower highs/lower lows, even as the exchange rate has pushed on higher.

It is hard to believe that sentiment to the USD can get any worse – derision of US monetary policy is only matched by doubts about the sustainability of the budget deficit. The Calafia Beach Pundit (here) noted that the USD is trading at record lows both in nominal and real terms:

In an AUDUSD context, this extreme in sentiment can be seen in the gap between the 20 period moving average and the monthly close in the AUDUSD.

Of course there are always two ways that this gap can close – the moving average catches up over time or the monthly price falls back into line. My sense is that with fundamentals likely to deteriorate, the odds are with mean reversion.

Conclusion

Given that a reasonable downside target for AUDUSD remains around 0.90, there is plenty of scope for patience. With half the short on at ~1.01, we’ll be looking for signs that the current thrust higher has run its course before adding materially to the position.

In any event, the strength in markets gives us reason to test our assumptions – cause based on these, our expectation is that we will experience a reasonable correction as we head into the end of QE2.  Last weeks selloff did not tick this box.

So how to characterise the information flow over recent weeks:

1) The economic growth cycle looks to be peaking – per OECD leading indicators (here) – this is consistent with a tightening of money in China and the final wave of stimulatory action in the US.

2) But, more importantly, monetary stimulus stepped up a notch with the response of the Japanese authorities. Perhaps there is a growing consensus that more monetary stimulus is inevitable – whether as part of the refinancing of the European periphery or by the US itself.

If it is expectations about more monetary stimulus driving the recent price action, then this should be reflected in a relative outperformance of real assets – think precious metals, energy and commodities in general – versus financial assets – bonds of all ilks and defensive equities. As a quick proxy consider the outperformance of the CRB against LQD since the Jackson Hole speech:

The CRB has certainly bounced hard over the last week and may yet retest its highs. And while we are here, we can push a little further down the risk curve via the relative performance of JNK as against LQD:

On the face of it, JNK does seem to do pretty well for itself when the Fed is actively buying securities. It too has enjoyed a steepling bounce recently though is short of its highs.

Also, those currencies that are home to the QE stimulus efforts should underperform.

It’s clear that Gold, as measured against US dollars, has barely stopped for breath as it has ridden the easy money train. The ‘hard asset’ Australian dollar may not have kept pace, but has certainly benefited from trade. While the carry trade pair of choice, borrowing in Japanese Yen to buy the AUD has been flatlining since the risk selloff last April.

Zooming in to the period since Bernanke visited Jackson hole the same trends prevail – XAUUSD beats AUDUSD that beats AUDJPY. And on even closer inspection, the same trends are replicated over the recent bounce. These charts seem to indicate that it is the US in particular that is driving the appreciation of real assets.

Conclusion

Recent price action suggests that capital flows have taken on some of the character of a flight from easy money – and particularly the US variety. Whether this is the moment when the ‘governments are debasing our currencies’ meme goes mainstream is beyond my reckoning.  If it is, then we can expect gold to lead real assets in a substantial spike higher.

Probably more likely though is that this thesis needs further testing – for example, as the expiry date for QE2 draws closer and the debate about further QE rises to the fore, then uncertainty should creep into the equation. It is for this reason that we remain under our target weighting in gold and energy in particular. We continue to expect volatility across risk markets as the first half of 2011 draws to a close.  Hang tight.

Postscript – Bruce Krasting at Zero Hedge succinctly looks at the question of ‘measuring the success of QE2′ (here)

So why act now? It’s because the enthusiasm for the Aussie Dollar is fading. We wrote about it the other day with respect to capital flows (here). Zooming in on weekly basis, we can see the slow turning of the Queen Mary (or is that a Capesize bulker?) in terms of the divergences in momentum, RSI and MACD. Look back in history, such events are few and far between and have a high correlation with corrections.

Another leg up in prices is not out of the question – it would be welcome if a little uncomfortable. But these indicators are clearing showing that the appetite for the AUDUSD is fading. Over the next 3 months, there is likely to be a increasingly not-so-subtle shuffle to the exits for the risk trade – we can expect the Aussie to be a casualty of this trend.

Conclusion – The portfolio has been underweight banks and industrial resources for some time – with counterveiling longs in energy, gold and agriculture (that may be due a further trim). The new short AUDUSD position is a six month view – the cost of carry will accrue to just under 3% over that period, so looking for a test of ~0.9000 in the first instance. In the event, that we do get a pop to 1.03/1.05 in the near term, then the position is likely to grow.

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Postscript

This article from FT Alphaville talks to the risks of an unwind in the AUDYEN carry trade (here)

But first speaking for the optimists, leveraged accounts have returned to the Aussie over recent weeks – though not in sufficient numbers to return open interest to March 2010 levels:

Considering that the AUDUSD exchange rate is bumping up against its recent highs, the relative lack of volume might possibly suggest that we are about to enjoy a capitulation spike higher that sees volume also make new highs.  More probably, the relative decline in volume is a sign of failing enthusiasm for the commodity trade – something that is clearer when looking at the total futures volumes:

This same lack of conviction is even more evident in the aggregate spot and forward currency flows against all currencies. By way of illustration, we use a money flow index, that combines volume with price, to gauge the relative strength of the currency. Note the divergence between the index and price that has been unfolding for months now. At the very least we can conclude that today’s price action is very different from that of March 2010.

Putting this into a mean reversion context, the current AUDUSD price looks pretty stretched and due for an pullback to at least the 0.90/0.91 level.

Chances are that the risk trade is losing steam as we head into the end of QE2. It’ll be interesting to see how the Aussie holds up. Historically, a cross of the moving average convergence/divergence on a monthly basis has been a reasonable signal for a change of trend. Remind me to check if we trade through 0.9000…

While leveraged accounts have returned to the AUD after a pre-Christmas sell-off, the declining trend in the size of the positions suggests that conviction is waning in this trade. This same pattern is evident in total open interest that peaked in April-10, failed a retest in October-10, and has more recently turned its skis down the slope:

The importance of the April-10 peak comes through when we look to at the total monthly transaction volume in the Australian dollar (spot and forward contracts):

While total volume in trade in Australian dollars has never regained the peak of October-08, the volume high in May-10 is the most significant recent watermark.  The following charts illustrate the trends in volume a little more clearly:

Given volumes have tended to rise over the longer term, we’ve used a Money Flow Index, that weights changes in price by volume, to gauge relative movements over time.  Typically, it peaks and troughs with the raw price data – and is used to measure overbought or oversold conditions.

There are two occasions in the data set back to 1990 (shaded in grey) where the oscillator diverges from price. The first had Money Flow peaking around Jun-07, a good twelve months before the AUDTWI followed suit.  More recently, while the AUD has been making new highs, volumes have been pulling the Money Index lower after a peak in April-10.  It would be uncommon indeed for this divergence to remain unremedied.

Conclusion – Trade in Australian dollars strongly suggests a correction is brewing. We expect the AUD to trade lower, perhaps significantly so, with the odds of a correction rising the closer we get to expiry date of QE2.