USD boosted by bond yields, AUD vulnerable

The USD rallied further overnight helped by a Fed FOMC statement that was less downbeat than in January, with no hint of any further quantitative easing. In combination with a solid February retail sales report and upward revisions to December and January, US bond yields pushed higher. US 2-year Treasury yields hit their highest since the beginning of August 2011, which given the strong correlation with the USD, provided further support to the currency.

The highest FX sensitivity to yield differentials is found in JPY, AUD, SEK, and CAD over the past 3-months. However, among these US yields have only widened against Japan over recent days meaning this currency is the most vulnerable. For the other currencies their yields have actually been widening against the USD. Over the near term, the USD is set to remain well supported, especially as data releases over the rest of the week will maintain the tone of strengthening economic activity.

AUD looks increasingly vulnerable to further short term slippage. At least partly explaining the recent drop in AUD/USD is a narrowing in Australia’s yield advantage over the US. A spate of weaker data over recent weeks has helped to undermine the currency including Q4 GDP data which revealed a far slower pace of growth than had been expected. Weak jobs data reinforced the view that the economy is spluttering.

The net result is that Australian interest rate futures have rallied and implied yields have dropped in contrast to the US where futures have sold off in the wake of strengthening economic data. The casualty of all of this is the AUD and it appears that further downside risks are in store for the currency. Indeed my quantitative models show that the AUD continues to trade well above its short term ‘fair value’. For those wanting to take medium term long positions in the AUD I would suggest rebuilding longs around 1.03-1.04 versus USD.

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