EUR/AUD: Short-Term Upside, Long-Term Downside

EUR/AUD: Short-Term Upside, Long-Term Downside

The EUR/AUD currency pair, which expresses the value of the euro in terms of the Australian dollar, has experienced increased volatility recently. In my previous article covering the pair, I did anticipate this; however, the likely direction of EUR/AUD was less clear at the time (volatility is independent of the direction of price).

The chart below shows recent price action using daily candlesticks, while the vertical blue line illustrates the date of publication of my prior article. At first, volatility remained subdued. After several days of further stability, the euro spiked against the Australian dollar (driven largely by AUD weakness rather than EUR strength), finding similar heights to those seen in August 2019.

EUR/AUD Price Action (Daily Candlesticks)(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)

The chart below adds some color to the recent moves, by zooming out to include all price history from the beginning of 2019 to present. The prevailing short-term trading range of EUR/AUD is illustrated by the shaded area; horizontal levels of 1.6610 and 1.5920 have been added to illustrate the bounds of this range.

EUR/AUD Trading Range from 1.6610 to 1.5920

At the moment, the pair is trading above the midpoint, having recently spiked through the 1.63 handle. The question now becomes whether the pair will attempt to find 1.6610, or fall back down toward 1.5920. If the status quo holds, though, we would favor the argument that the further EUR/AUD rises or falls from 1.63, the greater the risk of a reversion to 1.63.

Using volume profile analysis, we can see from the updated chart below that the level most supported by price and volume is approximately 1.6250 (just below the midpoint of the prevailing trading range).

EUR/AUD 1.6250

This is clear, as the pair is no longer trending in any particular direction; short bursts of upside are followed by downside. It is important to remember that both EUR and AUD have been popular currencies to short. Per data from The Commodity Futures Trading Commission’s weekly Commitments of Traders report, speculators have been net-short on the euro since September 2018 (see chart below).

Euro Speculative Positions

(Source: Investing.com)

AUD has also been a popular currency to short-sell; speculators have been net-short on the Australian dollar for even longer (since March 2018).

AUD Speculative Positions

(Source: Investing.com)

The fact that speculators have been significantly net-short both currencies is likely to make them both subject to short-term upside volatility versus currencies such as the U.S. dollar (the USD). Short-term volatility can send feedback loops through markets as traders feel the pressure to unwind these short positions. In this author’s view, it would seem that EUR positioning is more extreme and thus the euro is more vulnerable to a short-term spike.

EUR is, however, the more obvious short (as compared to AUD), given that EUR/AUD itself is a negative-carry pair. This means that the euro carries with it a lower interest rate than the Australian dollar; in other words, it costs money to hold euros in terms of Australian dollars (due to the yield differential). That means shorting EUR/AUD provides a leveraged trader with an income (positive carry). The natural bias then, is to the downside for EUR/AUD.

The daily candlestick chart below, for EUR/AUD, includes a green line which represents the one-year interest rate spread between German bunds (a proxy for euro rates) and Australian government bonds.

EUR/AUD Interest Rate Spread

It would appear that the improvement in the interest rate spread has coincided with the modest upside bias of the pair since the beginning of 2019. However, as shown in the chart above, the yield differential is still negative and thus favors AUD upside against EUR (or EUR/AUD downside).

The bond market’s most recent pricing of the spread at negative -1.43% compares to the short-term rates of the European Central Bank (or ECB) and Reserve Bank of Australia (or RBA), the central banks which represent EUR and AUD, respectively, of negative -0.50% (for Europe) and +0.75% (for Australia). Netting negative -0.50% off from +0.75% provides an implied one-year spread of negative -1.25%. This means the market is ultimately pessimistic versus the spread implied by central bank rates.

In the short term then, while the yield differential has now steadied with some consistency (supporting the stability of the current EUR/AUD trading range), we should probably expect to find EUR/AUD either consolidating in the current region of 1.63 and/or rising toward the 1.66 handle.

However, a breakout of this range (to the downside or upside) might require a monetary policy divergence, whereby either the ECB lowers rates further (or injects more stimulus, providing increased EUR liquidity) or the RBA lowers rates further. The former would weaken EUR/AUD, whereas the latter would improve EUR/AUD. If both central banks (the ECB and RBA) take similar easing measures, the status quo will probably remain.

For reference, as indicated by the table below, the next central bank meetings for the ECB and RBA will be held in March 2020, with the RBA meeting coming first. The RBA is not generally expected to cut rates, although they could surprise, which could lead to a sharp adjustment in bond markets and a significant spike in the EUR/AUD market.

Central Bank Meetings of ECB and RBA(Source: Investing.com)

As the euro has practiced expansionary monetary policy for some time, the market is possibly likely to be more sensitive to a rate cut from the RBA. Therefore, once again our bias should be cautiously bullish on the EUR/AUD in the near term. Even without a rate cut, the market appears to be erring on the side of optimism, which is probably unwise given that AUD is more exposed to the coronavirus threat than EUR (via significant export exposures to Asian countries most affected by the virus).

Bear in mind that there has been a flood of capital into USD and CHF recently, which have been viewed as safe-haven currencies in light of the coronavirus threat to global supply chains and financial markets. This has led to broad softness in both EUR and AUD (in addition to other commodity currencies like NZD). Should (or when) these USD inflows reverse, following improved risk sentiment, both EUR and AUD could find strength.

It was towards the end of January 2020 that markets truly reacted to the coronavirus news, with many pro-risk FX pairs (such as AUD/JPY, for example) experiencing sharp sell-offs. The following chart shows EUR/USD since January 20 through to present (daily candlesticks are used; the shaded area focuses on this period in question).

EUR/USD Drawdown

The chart indicates draw-down of over 2.8% since January 20 (although the recent spike has reduced this somewhat). The chart below shows AUD/USD similarly.

AUD/USD Drawdown

This chart shows draw-down of over 4% for AUD/USD, during the same period from January 20 to present. Therefore, we might consider the possibility that an improvement in risk sentiment could support AUD more than EUR, should markets mean revert. However, many other factors beyond the coronavirus are at play, and in the near term, the virus threat is likely to remain.

Therefore, for the next few weeks at least, we should expect EUR/AUD to remain range-bound with a modest upside bias from 1.63 through to around 1.66. The recent spike and fall in the pair shows us that there is no inherent bias in EUR/AUD with respect to coronavirus risks.

Should we see a significant improvement of risk sentiment though, EUR/AUD could present a short opportunity, provided that the RBA does not cut rates in March. This is because AUD/USD is likely to respond with greater volatility (to the upside) than EUR/USD (as it did to the downside recently). The better risk sentiment becomes, the more value the market will likely place on such factors as the negative carry of the EUR/AUD pair.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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