Supporting the Australian Dollar

The Australian Dollar has fallen around 11% over the last month. This is a very large and very rapid move for the currency of a major nation. How would you like to end up with 11% less in next week’s check? This is similar to what the average Australian will feel with every purchase of every imported good or service, just think of it as $4.50 gasoline and you’ll get an idea for the feel of it. Our outlook suggests that the change in the macro is correct but its initial impact has been over cooked.

The primary big picture changes that triggered this sell off are twofold. First, the slowing Chinese economy has been a primary destination for Australian raw materials. Secondly, the U.S. Federal Reserve Board announced its intentions to begin siphoning off the Quantitative Easing stimulus. This has triggered the unwinding of the carry trade.

China is Australia’s largest trading partner with total exports to China comprising more than 5% of Australia’s Gross Domestic Product (GDP). The impact of recent downward revisions to Chinese GDP has taken the wind out of the Australian economy.  The International Monetary Fund (IMF) cut their forecast for Chinese growth from 8% to 7.75% for 2013. HSBC and Barclays announced larger cuts in their projections and see Chinese growth at 7.4% rather than their previous estimates of 8.2% and 8.1% respectively for 2013. GDP forecast revisions of more than .5% tell us two things. First, economists aren’t great at forecasting when their margin of error is +/- 10% per quarter. Secondly, a .5% cut in Chinese GDP still leaves them in the enviable position of having the largest, strongest economy in the world.

The carry trade is based on borrowing cheap money from one country to buy assets in another country. The two primary components of a carry trade are the interest rate differential and the exchange rate between the two countries. The trade makes sense in a stable marketplace. Dollars borrowed in the United States at .25% are used to buy Australian treasuries yielding better than 3% and recently as high as 4.25%.  More importantly the Australian Dollar held its own throughout the global financial crisis. This made it a safe haven as the highly leveraged U.S. and Euro markets raced each other to the zero lower bound leaving Australia to benefit from both higher interest rates and currency appreciation. That’s a win/win in the carry trade.

The money that has poured into Australia can be seen in the rapid growth of their currency reserves. Foreign currencies were repatriated post haste during the financial crisis. Australia’s foreign exchange reserves declined from the all time high of more than $80 billion in May of 2007 down to $30 billion by January of 2008. Australia’s current reserves haven’t been this high since June of last year. June of 2012 also marks the low point for their currency in the last year.

The macro issues surrounding the global currency wars are beyond the scope of my day-to-day trading. However, the knee jerk response in the global currency wars due to Ben Bernanke’s suggestion that the Fed may begin to taper off the Quantitative Easing programs combined with the volatility in the Asian currencies and stock markets has created an overly bearish situation in the Australian Dollar. Their healthy balance sheet, excess foreign reserves and primary business of raw material and agricultural exports places them in a position to control the fortunes of their own currency, stock market and economy as a whole. They still have all the tools that we’ve already used to fight an economic downturn of their own. In fact, I’d say they’re holding a full clip while here in the U.S. we’re hoping we can pull back just long enough to reload. Therefore, the current prognosis lies in favor of a higher Australian Dollar going forward.

The commercial traders are well aware of the situation and they’ve been on a torrid buying spree in the Australian Dollar. In fact, they started buying in earnest once the Australian traded down to par (even money) with the U.S. Dollar, nearly doubling their net position over the last six weeks. We believe that the heavy commercial buying will cause the sell off to grind to a halt and protect us from much more downside risk. Therefore, we’ll be buying the Aussie as soon as we get some type of early technical reversal to trigger our long trade. We will then place a protective sell stop underneath the low for this move. Based on the current ranges and swings, we would expect to take profits between $.9750 and par to the U.S. Dollar.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

End of the Sugar Decline

The sugar market, currently trading around $.17 per pound has been drifting slowly lower since making its all time high of $.2957 per pound in August of 2011. Last week, the market fell through a key support level at $.1662 and traded down to $.1617 before reversing to close on its highs for the week. This could very well be the catalyst to rising sugar prices over the next few weeks.

The sugar market can be exceptionally volatile. Sugar’s average annual movement over the last five years is about 225% from high to low. This year, we’ve only seen a 20% range between the high and low. We expect volatility to increase with range expansion for the year’s range to show up in new highs. We also expect a near term increase in volatility as the market rejects the recent low and reverses course.

The sugar market’s decline has been quite orderly. This means there’s been low volatility. Low volatility compresses risk levels, which leads to tight stop prices. Tight stop prices allow more people to access the market. Tight stop prices also lead to added leverage. Smart traders view risk as a percentage of equity. Tight stop placement allows traders to add multiple contracts while maintaining their own risk tolerances. This ease of access and tight stop placement leads to ballooning open interest. Open interest recently peaked at just over 450,000 contracts. This is the largest open interest since January of 2008.

Staying with the technical characteristics we can compare the change in open interest to their price levels. Tying these observations to the Commitment of Traders reports then allows us to assign the change in open interest to individual trader categories like small speculators, index funds and commercial traders. This type of analysis shows that there were 95,000 new contracts added between March 1st and today. These contracts were all initiated between $.1684 and $.1778 per pound. Furthermore, the build in the commercial trader positions since mid-March is almost exactly 90,000 contracts.

The final technical piece lies in reading the chart itself. The weekly sugar chart shows last week as a key reversal bar. The textbook definition is a chart bar that makes a new high or low for the extended move indicating continuation of the trend before pulling an abrupt about face and closing beyond the previous bar’s high or low. The rejection of this new price level and quick return to previously traded prices indicates a market that has moved too far, too fast. The details of the setup show the weekly range for the week ending June 7th as $.1666 high to $.1632 low. Last week’s reversal bar traded down to $.1617, below the previous week’s low before closing at $.1678, above the previous week’s high.

Finally, we are just beginning the strongest seasonal tendency for October sugar. The seasonal strength lies between the middle of June and the end of July. We feel that the build in commercial long positions, coupled with the large increase in the speculative short position near their current breakeven levels will ultimately resolve its imbalance to the high side.

Last week’s key reversal bar leaves 90,000 contracts in jeopardy of being stuck holding the hot potato. Given the low volatility the market has been experiencing I believe that many of those new positions have pretty tight protective stop loss orders tied to them. Therefore, as this market turns higher it should begin to trigger these stops. The buying pressure triggered by the stop loss orders could very well kick off the seasonal strength. The first trend line resistance is just shy of $.18 per pound with further technical resistance around $.20 per pound. Meanwhile, since we are in fact bottom picking, a protective stop loss order should be placed no lower than $.1683.  The primary key to profiting from this trade will be the ability to gauge the buying pressure that comes from small speculators being forced out of their short positions.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Tidal Shift in the Bond Market

The recent spike in Treasury yields could very well be signaling a change in trend direction. We rarely try to pick tops or bottoms in major trending markets. It simply doesn’t pay. However, we’re seeing lots of corroborating evidence that this may signal a shift in the global macroeconomic outlook. Therefore, this is one of the rare times when a pull back within the interest rate sector may not be a buying opportunity. In fact, if this is the beginning of the Great Unwinding we need to focus on all of the evidence to obtain a complete picture view, all the way from the trading screens to the man on the street.

The trading screens always provide the first clues of market direction. It’s important to remember that prices and yields trade inversely to each other. Therefore, when the price of the security rises, the interest rate declines. The opposite is also true. This is why we can talk about all time high prices and record low yields in the same sentence. The 10-year Treasury Note is the global proxy for US interest rates.

The last leg of this rally began in late November of 2007. The employment situation was starting to deteriorate and interest rate adjustment was the primary tool the Federal Reserve used to pump life into a faltering economy – prior to the economic collapse. The Fed lowered rates by a quarter point in four out of the last five months of 2007. They lowered rates eight more times in 2008 and finally committed to a zero rate policy in February of 2010.

The combined inventive efforts at the Fed eventually drove the 10-year rate to an all time low just under 1.5% in the cash market and an all time low on the 10-year futures of 2.3%. This is where it starts to get interesting. The 10-year Note has been trading at a negative real return for over a year. This means the interest generated by the instrument’s yield would not keep pace with inflation’s erosion of principle. The recent sell off has pushed its nominal yield above 2% while inflation is expected to remain a hair under that mark. Thus, bringing our first, “normal” look at a yield curve in ages.

The high water mark set in early May was fueled in part by Japan’s concerted depreciation of the Yen. The markets were well prepared for this. The US has provided massive stimulus over the last five years. Europe has added their share over the last three years through Greece, Spain and now, Cyprus. The logical next step in a globally competitive devaluation race was obviously a form of Quantitative Easing by Japan. Commercial traders here in the US stocked up on 10year Notes, accumulating their largest long position since February of 2008. Their expectation was that we would continue pushing the zero bound interest rate plan.

This may very well be one of the rare times when the commercial traders are just plain wrong. Historically, they’ve been very good at forecasting rate direction. This time the largest trading group may have been faked out as a whole. Two important points bring this home. First of all, their buying did fuel a rally to new highs…by a hair. Secondly, the weekly chart is beginning to show an obvious reversal bar. Will this turn into an, “Everybody out of the pool,” moment? I doubt it. However, I do expect them to continue to offload recent purchases, which will build up resistance on any attempted rallies.

The other primary point to make is the effect of the rise in interest rates on the housing market and its effect on the anemic economic recovery 99% of us have participated in. The national average 30-year mortgage has climbed by nearly 25% over the last few weeks rising from 3.4% to 4.2% according to Bankrate.com. This will have a big impact on the housing market, which had just begun to clear some inventory. This will also affect mortgage refinancing just as the deadline for governmental forgiveness approaches. The result of the spike in interest rates has caused a decline in the broad S&P 500 of nearly 4%. Meanwhile, the homebuilders ETF (XHB) has declined by almost 10%. The homebuilders have been a primary driver of the broad market’s rally since 2012 gaining nearly 100% in two years.

Higher interest rates are the last thing any of the major economies can afford. Half a decade’s worth of rate cuts, Quantitative Easing and Operation Twist, etc. have created a coiled spring of leveraged money hunting for that last bit of yield. The major reversal bar in the 10-year futures coupled with a large, unprofitable, commercial trader’s position could leave them left holding the hot potato. At its worst, this spike in rates steers us towards stagflation. An environment with rising inflation and no growth characterizes this. How far it spills over into the markets is unsure. Please call with any questions as this may well mark the inflexion point of what has been THE dominant trend over the last five years.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.