The AUD/USD pair is coming to some important technical levels, retesting its highs from mid-June, but also probing the lower area of the consolidation zone it had seen throughout October ’09 till early May.

Let’s examine the factors affecting both economies and currencies.

Some Background

First though its important to know how we got here. The Aussie had a strong rally throughout 2009 as equities, commodities and other asset classes recovered from the severe financial crisis of 2008 and the global recession that followed. A lot of this rally was powered by central banks sharply reducing interest rates which helped to stimulate financial markets and a gearing up of manufacturing as inventories had been depleted and not restocked out of fear of a protracted recession and weaker demand in the developed world.

In Australia, swift action by the central bank – slashing rates from 6.75% to 3.5% – helped to lower mortgage payments and other debt services costs, while government stimulus in the form of tax rebates for consumers helped the economy to skirt an official recession as it had only one quarter of negative growth (1Q 2009).

What also helped was continued strong growth in China, as Chines banks were not as exposed to the financial products that soured in the wake of the financial crisis. With Chinese GDP growth hovering above 10% throughout last year, the country was hungry for Australia’s natural resources such as coal and iron ore. The strong demand buttressed the Australian economy and provided jobs in the mining and export sectors.

The Reserve Bank of Australia seeings the economy’s recovery sent signals that it would embark on a path of raising interest rates, which helped boost the AUD/USD pair. The prospect of higher interest rates made Australia a favored destination for carry trade where investors borrow in currencies of country’s with low interest rates – Japan and the US – and parking those funds in assets of country’s like Australia where they can collect higher yields.

In late 2009 and in the beginning of 2010, the RBA moved to raise interest rates so that the economy did not overheat and that the country’s housing market would not form a bubble. From October until February, rates rose to where they are now at 4.75%.

Those rate hikes had been priced into value of the AUD/USD during the rally of 2009, and throughout the 4Q of 2009 and 1st quarter of 2010, the pair moved mainly sideways, unable to move above 0.94. Some of this had to do with US Dollar strength and expectations that the US economic recovery may be stronger than anticipated, which increased expectations that the Fed would begin to raise interest rates themselves.

The Euro-Zone Debt Crisis

In May of 2010, the AUD/USD, from testing the area below 0.94 slid sharply as a result of the Euro-zone sovereign debt crisis. It infused financial markets with fear that the global recovery would be derailed. The AUD/USD fell to a low of 0.81 before the EU and ECB stepped in with various measures to stem the crisis. It was also reported that around this time the RBA intervened to keep its currency from falling below the  0.81 level.

Since then fear around the Euro-zone sovereign debt situation has eased and the Australian Dollar recovered a good amount of the ground lost in May, testing the 0.8750 area in mid-June and again as this article is being written.

Present

While the RBA rate hiking campaign  was derailed somewhat by the events in Europe, the fundamentals around the Australian economy remain strong. As we already saw the labor market has been tightening with a job boom fed by continued strong demand from China. While there are some concerns that Chinese growth is cooling, 1st quarter GDP growth was still up more than 10%. Also a row between the Australian government and the country’s mining companies over a tax of mining profits seems to have been settled, with mining companies winning and at the expense of the loss of the job of Australia’s Prime Minister Kevin Rudd.

The Australian economy continues to see housing prices increasing and with the increase in employment feeding consumer consumption, inflation remains a concern for the central bank. While they paused in their rate hiking campaign, the signs point to a continuation of tighter monetary policy – and higher interest rates in the near future which should help the Australian Dollar. That is considering we don’t see a new financial crisis come first.

In the US, the economic picture is cloudier as a string of weaker data has caused the Fed to downgrade their outlook for the recovery. Private sector employment growth has been disappointing and the housing sector continues to suffer the hangover of the popped housing bubble. While the restocking of inventories helped boost manufacturing activity, that may be cooling as well. The hope by central bank officials was that consumer and business spending would power growth in the 3rd and 4th quarters, as government stimulus ran out and the central bank turned off the spigots of its super loose monetary policy. However, with the weaker US fundamental data which includes very tame inflation (and some concerns of deflation) interest rate increases by the Fed have now been pushed back into next year. That has hurt the US currency.

The Outlook for the AUD/USD

The implication for the medium term then is that the Aussie should reclaim its strengthening bias against the greenback and has already done so in the past month and a half. If the pair managed to break above the 0.8850 level and hold it, it would mean an attempt to rally to the high of the consolidation zone we mentioned before near the 0.94 area.

This scenario depends on China’s growth not falling too much, and that the US recovery will not regain enough of its previous momentum that would make the Fed think twice about keeping monetary policy too loose for too long.