Euro firmer, AUD vulnerable to risk gyrations

A surprise drop in US August consumer confidence which dropped to its lowest since November last year put a dampener on markets and notably the VIX index edged higher. Consequently treasuries rose and equities slipped despite a firmer than expected increase in US house prices in June. The confidence data adds the pressure on Fed Chairman Bernanke to give some indication of a further round of quantitative easing during his speech at Jackson Hole on Friday.

An upward revision to US Q2 GDP and a bounce in July pending home sales today are unlikely to change this perspective although the Fed’s Beige Book will likely show some moderate improvement providing the Fed with useful information.

Separately decent debt auctions in Spain and Italy helped to calm Eurozone market nerves further amid hopes of European Central Bank (ECB) action next week despite the news that Spanish region Catalonia formally asked for EUR 5 billion in funding. As a result the EUR retained a firmer tone.

Contrary to expectations, EUR/USD continued to push higher. Just why the currency is strengthening given the significant event risk in the days and weeks ahead is questionable although in part the move is attributable to an ongoing short squeeze. Hopes of constructive ECB action next week taken together with Fed quantitative easing expectations have helped to put the USD on the back foot, allowing the EUR to take advantage.

Admittedly the drop in Eurozone peripheral bond yields is certainly helpful for the EUR, while my short term quantitative ‘fair value’ estimate for EUR/USD suggests more upside too. Nonetheless, given the risk that so much could go wrong in the weeks ahead I am loathe to get on the bullish EUR bandwagon. While EUR/USD and EUR on the crosses will likely remain firm ahead of Jackson Hole I expect the EUR to struggle to hold onto gains into next week.

AUD has lost ground since around 10 August. This has roughly coincided with a rise in risk aversion over recent weeks. Indeed, AUD maintains a strong correlation with risk aversion and is therefore highly susceptible to swings in risk appetite. Additionally renewed China worries have also dampened the attraction of the AUD given the increasing dependency of Australia’s economy to China both directly through trade and indirectly via commodity prices.

While I remain positive on the AUD over the medium term, the high level of speculative positioning in the currency suggests some vulnerability to profit taking over the short term, with AUD/USD vulnerable to a drop to technical support around 1.0282. Much will depend on news out of China in terms of AUD direction, with Chinese stock market gyrations also providing some influence.

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