The Australian dollar has been the top performing emerging market currency in this week and it put together its broadest rally in months and was at par with levels not seen since late 2024.
Trading at around 0.69, the currency has been able to perform better than all the major currencies such as Japanese yen and the US dollar, and based on technical indicators there seem to be no signs of a reversal in the near future.
What started off as a recovery due to better risk sentiment, has now divided into something much more significant. Traders are now turning their attention to domestic fundamentals, especially Wednesday’s fourth-quarter consumer price index report that could decide whether the Reserve Bank of Australia increases interest rates as early as next month.
Risk appetite was back but the fundamentals came to the fore.
For much of January, global markets were preoccupied with digesting news in relation to US tariff threats and geopolitical tensions. These issues have in large part passed, and investors have been able to refocus on economic data and central bank policy. This shift in sentiment has especially boosted high-beta currencies such as the Australian dollar that are prone to rising in markets which are risk-on.
But this is not just a story of sentiment. The rally in base metals such as copper and iron ore appear to suggest traders are taking into account the more positive prospects for global growth. For an economy with plenty of natural resources, such as Australia, this is a strong positive signal.
Even more importantly, the Australian dollar is gaining not only against the US dollar but also against other currencies.
Gains against the euro, pound and Swiss franc confirm that the cause is not US dollar weakness but real Australian asset demand. Inflation is extremely important in RBA policy. And now all eyes are on the fourth-quarter CPI report, which is due out on Wednesday, which Reserve Bank Governor Michele Bullock explicitly flagged as a key data point ahead of the February policy meeting. It is now clear from the central bank that further tightening will continue if inflation does not come under control.
This is where things get interesting: the market expectation is for inflation to pick up to an annual rate of 3.6% up from 3.2% in the prior quarter. This would see inflation far above the RBA’s 2-3% target band, and vindicate the bank in its repeated warnings over persistent price pressures.
Adding fuel to the fire were the employment figures for December.
Following consecutive monthly increases in November, in Australia, there was a surge in jobs, a fall in the unemployment rate and an increase in household spending of more than 1%. These are not the features of an economy that requires a relief of interest rates.
But money markets are already pricing in almost 60% chances of a rate hike in February. A hotter-than-expected CPI print would throw these odds even higher and give further support to the Australian dollar.
The Fed Factor: Divergent Policy
While Australia is deliberating on whether or not to raise or lower rates, the Federal Reserve seems firmly on hold. Despite constant pressure from the political circles, Chairman Jerome Powell is grappling with inflation data that remain sticky and economic conditions that do not merit rate cuts in the near future.
No surprises are in store at the pending FOMC meeting. Economic projections were updated in December and the data since has only led to further expectation of no change in policy. This means that if the RBA tightens, the interest rate differential is likely to change in favour of currency traders in the near future.
The story is told by the correlation data. The Australian dollar is now displaying a strong inverse correlation to the US dollar index and strong positive correlation to China-sensitive assets such as yuan, copper and gold. After a period of volatility, the traditional macro-economic relationships are re-establishing themselves.
Signs of Futures Positioning Shift
According to the latest Commitment of Traders data, there has been a change in positioning in the futures market of the Australian dollar. While this report was put together before this week’s sharp rally it’s highly likely that traders have already shifted to a net long exposure.
Even more important, asset managers are regaining interest. These institutional players tend to follow momentum after a trend is established and the technical setup is indicating that they are accumulating bullish positions.
Technical Picture Assistance to Bulls
From a technical point of view, AUD/USD has breached key levels of resistance, and is now testing the 2024 highs near the 0.6940. Implied volatility is moving from lower levels and options risk reversals are trending higher, a sign of sorts of demand for call options is stronger than demand for puts.
While the pair may look stretched in the short-term, a significant pullback is not likely to be seen unless there is a significant change in risk sentiment globally or domestically. The next target for the bulls is the psychological level of 0.70 and if there is a break above this would pave the way for a move towards the 2023 highs later in the year.
What’s Next?
The journey of the Australian dollar now depends on the release of Wednesday’s inflation report. A strong report would cement the expectations of a rate hike in February and have the fuel required to send AUD/USD to 0.70 and above.
But the bigger picture is also important. The Chinese economic situation is showing early signs of stabilising, the US dollar seems to be weakening and seasonal trends are favourable for Australian dollar strength Q2 onwards.
For the traders who have been sitting on the sidelines, Wednesday is a very clear catalyst. Whether this turns out to be a tactical bounce or the beginning of a sustained uptrend will depend heavily on what the inflation data turns out to be and how the RBA reacts.
One thing is certain, the Australian dollar has momentum, the attention of the markets and better fundamentals. This is a combination that usually does not fade very quickly.
Disclaimer:- This content is compiled from multiple public sources; we do not assume responsibility for accuracy.
