Is
The Aussie A Leading Indicator?
By
Darrell Jobman
Down
under may be over the top. If you doubt it, then
what’s it mean when commodities trend down when the
Australian dollar weakens against the US dollar?
To
a large extent, fundamental analysis involves
extrapolating the future from the events of the past
as analysts review historical numbers in search of
identifiable trends. Traditional technical analysis
suffers from the same backward-looking drawback when
it relies on traditional moving averages, arcane
chart patterns, and a variety of measurements to
indicate when or if a market or security has become
overbought or oversold.
The
purpose of investing, however, is not to identify
what has happened but rather to anticipate what is
likely to happen. One of the best ways to look and
think forward comes from studying how the trend of
one market affects another. Most often this is
called intermarket analysis.
As
capital flows from one long-term theme to the next,
it typically shifts its geographical emphasis. In
recent years money has poured into Asia in search of
superior investment returns and then out again with
almost single-minded ferocity. In 1998 capital
outflows from countries such as Singapore, Thailand,
Indonesia, the Philippines, and Malaysia helped
create a financial markets crisis that spilled over
to Russia and then Brazil. Capital continued to flow
into the U.S. dollar to help finance the tech bubble
that eventually began to collapse in 2000 before
turning towards Europe to take advantage of higher
real interest rates.
CURRENCIES ARE KEY
In
many respects, currencies act as both gateways and
signposts for ongoing macro trends. When a currency
is appreciating relative to other major currencies,
it shows which direction capital is moving toward
and, perhaps just as important, which direction it
is moving away from.
From an intermarket perspective, the trend of the
Australian dollar against a host of other currencies
is often quite instructive. The Australian dollar is
one of the “commodity currencies” (along with the
Canadian dollar, New Zealand dollar, and often the
South African rand) because it tends to move higher
or lower in tandem with or ahead of commodity
prices.
The
key is that a long-term rising trend for commodity
prices will typically coincide with, or even be led
by, appreciation in the Australian dollar relative
to the U.S. greenback. A reversal lower and
subsequent weakness in this currency will serve as
an early indication that the bull market for
commodity prices may be coming to an end.
Long before fundamental analysts begin factoring in
the impact of lower raw materials costs (to the
detriment of producers and benefit of consumers) and
technical analysts begin to notice that sectors
previously under pressure are beginning to rise
while those that were recently strong are now
breaking lower, intermarket analysis will have
indicated that a trend change is on the horizon.
END OF COMMODITY BULL?
Take
a look at figure 1, which shows Australian dollar
futures and crude oil futures. The Australian dollar
bottomed out in 2001 and began to trend higher as
crude oil prices touched down below $20. From 2002
into 2005, the Australian dollar appreciated
steadily relative to the US dollar as commodity
prices in particular trended higher.
Figure 1: The Leading Aussie.
From 2002 to 2005 the Australian dollar relative
to the US dollar trended higher. Note that
crude oil prices followed that trend.
Recent weakness has pushed the Australian dollar
below the major support line that helped to define
its positive trend. Capital is no longer moving away
from the U.S. dollar and instead toward those
geographic areas that tend to benefit from stronger
commodity prices. The flow of capital through this
currency gateway indicates that the present
commodity-oriented bull market may be drawing to a
close.
Figure 2 compares the longer-term trend for the
Japanese yen relative to the Australian dollar to
the trend for crude oil prices. Crude oil prices hit
multiyear price peaks in both 1990 and 1997, at or
very near to the bottom for the yen versus the
Australian dollar. Drawing a trendline under the
bottom of the JPY/AUD cross-rate, the yen appears to
be making a bottom once again. If so, yen strength
going forward would serve as a very compelling
indication that oil prices are also making a
significant price top.
Figure 2: Crude
Oil VS. JPY/AUD. If the yen
strengthens, it may mean that oil prices have
made a significant price top.
The
point is that Australian dollar weakness against the
US dollar tends to forecast declining commodity
prices, while the Australian dollar moving lower
against both the US currency and the yen tends to
confirm that energy prices have made a cycle top.
FOLLOWING AUD’s LEAD
In
effect, we have taken one currency, the Australian
dollar, and turned it into an intermarket indicator
with implications that run from the forex markets to
the commodity markets and can even be carried to the
equity markets.
When the Australian dollar is trending higher,
investors should concentrate on the long side of the
commodity markets while adjusting equity portfolios
away from the more consumer-oriented names and
toward those companies that directly benefit from
the prices of stronger raw materials. When the
Australian dollar stops appreciating against the US
dollar, yen, and euro, investors should begin to
move to a more neutral or negative stance on the
commodity markets while shifting equity markets
portfolios away from the more cyclical sectors and
back toward more consumer-oriented issues.
The
macro view holds that a major cycle top in the
Australian dollar indicates the start of an
investment sea change in any number of seemingly
unrelated markets. However, the analysis of
long-term chart relationships, while obviously
important, only takes you so far. After all,
recognizing a likely trend change that may be weeks,
if not months, away does not make for effective and
profitable trading.
FINDING A USEFUL FOREACST
What
is more useful is having forecasts of likely trend
changes on which you can act. One software program
that provides such forecasts is VantagePoint
Intermarket Analysis Software, which uses neural
networks to analyze the relationships between a
variety of different markets. In the case of
Australian dollar futures, the software integrates
data from the British pound, US Dollar Index, euro,
gold, yen, and Swiss franc, as well as the US equity
and bond markets to create short-term forecasts of a
10-day moving average for four days into the future
and a five-day average for the next two days.
With these forecasted moving averages, you can
anticipate a trend change that gives you an
indication of when to trade. When the blue line
crosses down through the black one, as it did ahead
of price downswings in March, early May, late June,
August and September, the software is effectively
saying that, based on intermarket relationships, the
expected trend for this currency has turned negative
(see Figure 3).
Figure 3:
Anticipating Trend Changes. Moving
average crossovers can be used to anticipate
trend changes so you know when to trade. On
this chart it is relatively easy to identify
where the trend changes took place.
With the Australian dollar moving sequentially
lower, the macro argument was that commodity prices
should now be in the process of making a top before
turning lower. Gold futures prices did make a price
peak in March concurrent with the Australian dollar.
VantagePoint software created sell indicators for
gold in March, April, June and mid-August (see
Figure 4), but as traders speculated about the
threat of higher inflation rates resulting from
newly created government debt in the aftermath of
Hurricanes Katrina and Rita, gold prices again rose
to new highs, a function of the “Hurricaneomic”
effect, a term coined and trademarked by Louis B.
Mendelsohn, developer of the VantagePoint software.
Figure 4: The
Price of Gold. If you compare this
chart with the one in Figure 3, you’ll see that
they move almost in sync. The only exception
was the sudden surge in gold prices during
October 2005, which could have been due to the
government debt created by hurricanes Katrina
and Rita.
Crude oil futures also topped in late March and
early April before trending lower into May. Energy
prices then turned higher, as Figure 5 with the
five-day predicted moving average (blue line) and
five-day actual moving average illustrates,
extending prices into new highs in late August as
traders considered the effect of the extraordinary
damage to supply facilities due to Hurricane
Katrina.
Figure 5: Crude
Oil. Crude oil also followed a
similar pattern to gold and the Australian
dollar. Crude oil futures topped in late March
and early April and trended lower into May.
After that, energy prices trended higher.
Any
broad market or index will always have leaders and
laggards, as some markets may be more affected by
special events. Gold prices, for instance, turned
down concurrent with the Australian dollar
initially, while crude oil prices showed late-cycle
strength.
LOOKING AT THE BIG PICTURE
The big-picture argument is that as long as the
Australian dollar continues to weaken against the US
dollar, commodity prices will trend lower. When the
Australian dollar starts to depreciate relative to
the yen, crude oil prices should be at or close to a
top. This suggests that traders, especially those
following new sell indications for the Australian
dollar, should be looking for entry points into the
short side for metals and energy-related futures
contracts.
Intermarket analysis on a long-term or macro level
can serve as a valuable tool to confirm the presence
of major trends. Once these trends or any potential
impending trend change has been identified, the next
step is to utilize a highly accurate, shorter-term
timing method based on predicted price trends to set
up entry and exit points. This allows traders to
take positions with confidence in the direction of
the longer-term trend while at the same time
creating shorter-term entry and exit points to
maximize profits along the way.
Darrell Jobman, senior market analyst for
www.TradingEducation.com, is an acknowledged
authority on the financial markets and has been
writing about them for more than 35 years.
Related Reading
Jobman, Darrell [2005]. “Hurricaneomics: Weathering
Today’s Financial Storms,” Working Money:
October 11.
VantagePoint Intermarket Analysis (www.tradertech.com)
MetaStock (Equis International)
