Australian Dollar Showing Long-Term Negative Signs

- Technical studies show AUD/USD looking decidedly bearish longer-term

- Both fundamentals and technicals are aligning and pointing down

- Westpac sees interest rate differentials widening in USD's favour

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The Australian Dollar is currently looking vulnerable to long-term weakness against both the Dollar and British Pound, both from a fundamental perspective and from a technicalperspective.

The fundamental outlook for the pair has shifted since the US Federal Reserve raised interest rates to 1.75% at its last rate meeting on Wednesday March 21, as it now means US interest rates are higher than Australian interest rates for the first time in decades.

Australian interest rates remain at 1.50%.

(Images courtesy of tradingeconomics.com) 

Meanwhile, the Bank of England has maintained the view that interest rates will need to rise over the course of coming months with this week's Monetary Policy Committee meeting revealing two members of the nine-person committee want interest rates raised immediately.

Markets ascribe a non-neglible chance of a May interest rate rise, which should take the UK's basic rate to 0.75%, and in the process close the door on the Australian Dollar's rate advantage.

Analysts at Morgan Stanley have today confirmed they believe the GBP/AUD exchange rate is likely to move higher and are therefore maintaining their 'Long' GBP/AUD trade in their portfolio.

"Australian economic data have continued to underperform, most recently in skilled vacancies. RBA Governor Lowe previously emphasised that near-term rate hikes are unlikely. Meanwhile, GBP remains in a strong position to rally," says Hans Redeker with Morgan Stanley in London.

Interest rate differentials are probably the biggest driver of FX at present, with currencies that have a higher interest rate vis-a-vis other currencies normally appreciating versus their counterparts because they attract greater foreign capital inflows, because they offer investors higher returns.

It is not just the current differential that matters, however, but also the expected future differential and whether it is likely to widen further or harmonize. Market expectations drive markets even more than actualities, and current expectations are for the Australian and US interest rate differential to widen still further as US rates rise quicker than Aussie rates.

Australian lender Westpac highlights how Australia and the US appear to be pulling in opposite directions from the perspective of interest rate-setting policy.

In Australia the body which sets base interest rates is the Reserve Bank of Australia (RBA), whilst in the US it is the Federal Reserve, and Westpac note how the messages coming from each of these two institutions appear to be diverging significantly, with the Fed hailing much faster growth and the RBA predicting a slowdown in growth, if anything.

"The US Federal Reserve has raised its growth forecasts for 2018 and 2019 just when it appears the RBA might be reconsidering its growth forecasts to the downside. Australian interest rates look set to be a lot lower than the US over 2018 and 2019," says Westpac.

Clearly given the extent to which interest rates drive currencies, this appears to suggest downside for the Aussie Dollar versus the US Dollar, but what do the charts say?

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Final Wave Lower on Long-term Chart?

There does seem to be evidence that the AUD/USD chart is showing the potential for more downside in the long-term, although this would be subject to bearish confirmation from a break below the lower boundary of the current rising channel at circa 0.75.

Until that happens the charts continue to be bullish in the medium and probably even the long-term.

Nevertheless, assuming such a break were to happen - and given the bearish fundamentals outlined above, that's not a possibility we can rule out - what would it say about the longer-term prospects for AUD/USD?

The short answer is that they would probably be quite bearish and see the exchange rate continue down to retouch the 0.6827 lows at the very least.

The reason for this forecast is shown on the 3-weekly period, long-term, chart below.

The bracketed number labels - (1), (2), (3), (4) and (5) - are what as known as Elliot Waves which come from a branch of technical analysis which uses wave patterning and cycle information to help establish forecasts.

The basic idea is that markets go up and down in repeating five wave patterns with waves 1,3 and 5 moving in line with the broader trend and waves 2 and 4 correcting the trend. At the end of each 5- wave pattern there then forms a bigger correction composed of 3 waves (labelled a,b and c) before the next 5-wave cycle starts again.

The basic blueprint of the 5-3 repeating pattern is shown in the diagram below.

(Image courtesy of StockCharts.com)

Our view is that AUD/USD appears to be in the middle of one of these cycles, more specifically at the end of a large wave 4 on the 3-week chart.

If this is correct then when wave 4 finishes it will evolve into wave 5 down, which based on research, will probably take the exchange rate all the way down to as far as the trough of low of wave 3, at circa 0.6830, if not even lower.

The MACD in the bottom panel backs up our theory that the pair is in the wave 4 of a large Elliot wave.

It formed an extreme low at the end of wave 3 and then rose back up above the zero line during the formation of wave 4 which is a classic sign an Elliot Wave is forming.

When wave 4 has finished the MACD will start to move lower again along with the exchange rate as wave 5 down evolves (see blue line on chart above).

The MACD will cross back below the zero-line and forms a shallower hump at the apex of wave 5, thus normally creating a bullish convergence with price action at the end of 5, and heralding a move higher.

The MACD works best at identifying waves and wave counts when it is on a specific 5,31,5 setting and the wave in question is between 100-140 bars in length, which explains why we are using a bespoke 3-week chart so at to get the best fit.

On a 5,31,5 setting the indicator is also known as an Elliot Wave Oscillator as Elliot Wave analysts use it in their work to help them with wave forecasting.

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