AUD/USD: Trading the RBA Interest Rate Decision

01/30/2009 11:33 am EST

Focus: FOREX

The Australian dollar is likely to face increased selling pressures over the following week as the Reserve Bank of Australia is widely expected to lower the benchmark interest rate by 100bp to 3.25%, which would be the lowest level since 1963.

Trading the News: RBA Rate Decision

What's Expected:
Time of release: 02/02/2009 03:30 GMT, 22:30 EST
Primary Pair ImpactedAUD/USD
Expected: 3.25%
Previous: 4.25%

Effect the RBA Rate Decision Had on AUD/USD Over the Past Three Releases

December 2008 RBA Rate Decision

RBA Governor Glenn Stevens and company continued their easing cycle as they lowered the benchmark interest rate by 100bp to a six-year low of 4.25%, and are likely to lower borrowing costs further over the coming months as the $1T economy teeters on the brink of a recession. Falling home prices throughout the region, paired with fading demands from the global economy, have certainly dragged on the outlook for growth, and as global trade conditions remain far from favorable, economic activity is likely to weaken further throughout the first half of 2009. Mr. Stevens said that the rate cut "was warranted now, to take monetary policy to an expansionary setting," and went on to say that the outlook for growth could weaken further as policy makers expect firms to cutback on "plans for investment and hiring."

November 2008 RBA Rate Decision

The RBA reduced the key interest rate by 75bp to a three-year low of 5.25% from 6.00% despite expectations for a 50bp cut. The minutes of the November 4th policy meeting showed that the central bank decided to take a pre-emptive move to support economic activity as they expected the spillover effects of the financial crisis to "have a significant effect on business and consumer sentiment," which raised speculation that the policymakers may continue to ease policy further over the coming months as fears of a global recession intensify. Moreover, the reserve bank expects economic activity to remain subdued well into the next year as the emerging economies around the Pacific find themselves in troubled waters, and may prompt policymakers to lower borrowing costs even further as demands from the global economy deteriorate.

October 2008 RBA Rate Decision

The Reserve Bank of Australia lowered the benchmark interest rate by 100bp for the first time since 1992 as fears of a global meltdown intensified. The RBA minutes showed that the central bank slashed borrowing costs for the second consecutive meeting to lower the interest rate to 6.00%, stating that the unexpected move was "appropriate" in order to stave off further downturns in the $1T economy. Meanwhile, governor Glenn Stevens said that the risk of a "global catastrophe" has died down as a result of the extraordinary efforts taken on by policy makers worldwide, but has raised speculation that the RBA will continue to ease policy further as the major economies around the world slip into a recession.

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How to Trade This Event Risk

The Australian dollar is likely to face increased selling pressures over the following week as the Reserve Bank of Australia is widely expected to lower the benchmark interest rate by 100bp to 3.25%, which would be the lowest level since 1963. A Bloomberg News survey shows that 11 of the 20 economists polled forecast the central bank to lower the cash rate by 1.0% as the $1T economy teeters on the brink of a recession, while Credit Suisse overnight index swaps are showing that investors expect the RBA to lower borrowing costs by more than 200bp over the next 12 months. The data suggests that policy makers will continue their easing cycle in an effort to keep the economy afloat, and despite the extraordinary efforts taken on by the government, the outlook for growth remains bleak as demands from the global economy deteriorate at a rapid pace. Consequently, the trade surplus narrowed to A$1.45B from A$2.96B in October as exports plunged 4% during the month, and growth prospects are likely to deteriorate further over the year as firms continue to hold a negative outlook for the economy. The NAB business confidence index held below zero over the last 12 months, and as sentiment remains near a record low, firms are likely to cut back on employment and spending as the leading indicator foreshadows a worsening outlook for the economy.

The Westpac leading index slipped 1.0% to 253.5 points in November after falling 0.2% in the previous month, and pushed the annualized reading into negative territory for the first time since 2001, which suggests that the economy is likely to face its first recession in over a decade. Moreover, private lending in the region fell 0.3% in December, which marked the first contraction since 1992, and financial uncertainties paired with the downturn in the banking sector are likely to drag on the real economy as credit conditions remain far from normal. Nevertheless, as risk aversion remains a dominant theme across the financial markets, the higher-yielding currency could face increased headwinds throughout the first half of the year as investors continue to curb their appetite for risky assets.

Expectations for a RBA rate cut certainly favor a bearish outlook for the Australian dollar, so we would need a clear shift in the policy outlook to even consider a bullish Aussie trade for the given event risk. Therefore, if the central bank explicitly states that they have concluded their easing cycle and plans to hold a neutral outlook over the near term, we will look for a green, five-minute candle following the decision to generate a long two lots of AUD/USD. We will then place our initial stop at the nearby swing low (or reasonable distance), and this risk will determine our first target. Our second target will be based on discretion, and in order to preserve our profits, we will move the stop on the second lot to break even once the first trade reaches its target.

On the other hand, as central banks around the globe adopt a zero interest rate policy (ZIRP) with the International Monetary Fund forecasting a global recession, the RBA is likely to take pre-emptive move to avoid a severe downturn in the economy, and may continue to ease policy further over the coming months in order to stimulate the economy. As a result, a 100bp rate cut or greater paired with dovish commentary would certainly favor a bearish outlook for the commodity currency, and we will follow the same strategy for the short as the long position listed above, just in reverse.

By David Song, currency analyst, DailyFX.com

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