Is AUD Poorly Positioned Heading Forward?

In today's trading we saw the AUD/USD pair fall rather strongly, as the USD strengthened against most of its rivals. However, we have see the pair again rejected at the 1.02 level. For the most part, the pair has been in sideways price action throughout the first two months of 2011 as it has been unable to push above 1.02, though at the same time is have been setting higher lows during the period.

The Aussie has a spectacular run throughout 2010 as its economy was bolstered by strong demand from China for its exports of raw materials including iron ore and coal. It also had a very strong advantage in that the central bank - facing a mining jobs boom - was one of the few central banks from the "developed world" raising interest rates helping to increase the interest rate differential between it and the other major central banks.

While the economy still enjoys strong fundamentals, including an unemployment rate that at 5% is at "full employment" the two factors we described above may wane in helping to sustain the currency and could mean a dip back below the parity level.

First, China is trying to reign in its economy with higher interest rates of its own. Inflation is a large concern as is the chance that Chinese banks have lent out too much credit which could cause a financial crisis. China has raised rates 3 times since October, bringing its benchmark interest rate from 5.31 back in September 2010 to 6.06 in February. More may be needed to cool the economy a sufficient amount to get a handle on inflation. That can mean less industrial production in China and therefore less demand for Australian goods.

We saw exports in Australia for the month of January fall by 4%, though much of that was due to the impact of recent flooding. Still further attempts by China to tighten policy will have an adverse effect on Australian exports, and can cause the AUD some problems.

The Aussie's second reason for strength, its interest rate differential against other developed countries, will also not play as important a role going forward. With the price of Brent Crude oil contracts climbing above $115 it has created a lot of anxiety in central banks that it will fuel inflationary pressure.

That has caused the ECB to telegraph an upcoming interest rate increase, and traders are pricing in a Bank of England increase in the coming months. As global interest rates play catch up, the Reserve Bank of Australia is in a wait-and-see mode as it assesses the pass through of the damage that was caused by the strong flooding and recent cyclone.

Therefore the AUD may lose some of its interest rate advantage. While the US Fed is not close to tightening policy - in addition to the ECB and BOE, we have the Bank of Canada on the cusp of needing to being to raise interest rates. If the AUD falls against the EUR, GBP and CAD those effects will be felt in the AUD/USD pair as well.

Therefore, the factors that could hamper AUD strength are there - higher Chinese interest rates and higher oil prices causing central banks to hike rates. They are not givens, but it looks pretty clear that oil prices will remain elevated for the time being.

If these factors materialize then the Aussie may be poorly positioned heading forward for the next few months. It's worth keeping an eye on them in anticipation of Aussie weakness.

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