Simple EUR/AUD Mean-Reversion Trade

11/04/2011 6:00 am EST

Focus: FOREX

Whether through renewed euro strength or aussie weakness, yield differentials between the currencies look poised to reverse in favor of the euro in the months ahead. Here is a trade idea designed to capitalize.

With all that has been going on in the markets over the past several weeks, we have begun to notice some interesting price action in one particular cross that has been on our radar in recent months.

Despite what has been a very turbulent time in the Eurozone, the EUR/AUD cross rate has failed to post any additional declines beyond its multi-year lows posted back in July just under 1.3000.

Instead, the market has since been locked in some choppy consolidation which we contend could be the start to the formation of a material medium- and longer-term base.

Remarkably, this is a market that has fallen off a cliff since posting record highs by 2.1000 in 2008, with the price dropping dramatically down towards record lows in the 1.2000’s. This is a staggering move of 80 big figures in a three-year period.

However, we have since seen the monthly RSI begin to turn back up from oversold levels, and the indicator is helping to strengthen our trend reversal bias.

chart
Click to Enlarge

Technically, all markets should adhere to some form of mean reversion, and it is clear that this market has plenty of room to correct at this point to allow for a move back into its average price range somewhere in the 1.5000-1.8000 area.

See related: The Max Range Extension Trade

At present, we are currently nearly 20 big figures below the low end of the average range over the past 25 years, and at a minimum, we see good reason for the market to correct back towards this previous support area (now turned resistance) before even considering the possibility of longer-term bear trend resumption.

However, fundamentally, we do not see reason for bear trend resumption, and in fact, we would argue that this cross rate is on the verge of a major bullish reversal and start to a long-term uptrend.

NEXT: The Fundamentals That Suggest a Bullish Reversal

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We must remember that markets do not trade on how bad things are or how good things are at the moment. Instead, they trade on what has been priced in and react to what has not been.

While we concede that the situation in the Eurozone is dire at the moment, we also believe that the worst-case Eurozone scenario has now been priced into the market, just as the worst-case scenario had been priced into the US economy back in 2008.

With Australia, we do not see the downside as having been priced in appropriately at this point, and with yet another wave of the global recession expected to spread east to China (this is what we believe), we see Australia in a position to suffer more than markets had anticipated, which in turn will start to weigh more heavily on the Australian dollar on a relative basis.

We are already starting to see signs of slowing in China, and the Reserve Bank of Australia (RBA) has now moved towards a more accommodative stance, recently cutting rates by 25 basis points (bps).

On the other hand, we also see the cross in a position to benefit if we are wrong (about things getting worse) and the Eurozone manages to exceed expectations and recover more aggressively than anticipated.

Any signs of sustained recovery and optimism out of the region will infuse a fresh demand for the euro, and in turn, likely result in liquidation in many of the currencies that had benefited as alternatives during the Eurozone crisis.

The Australian dollar is one of these currencies, and we would expect that this type of scenario would open the door for a more aggressive reversal of accommodative policy from the European Central Bank (ECB) and trigger a major narrowing in yield differentials back in favor of the euro. One way or another, we look for yield differentials to narrow in favor of the euro currency.

Trading Strategy

  1. Buy EUR/AUD at current levels (1.3300’s); stop loss on a weekly close below 1.2900
  2. Look to move stop loss to cost and book partial profits on a test of 1.4000
  3. Target a move towards 1.6000 on the remainder of the position

By Joel Kruger, technical strategist, DailyFX.com

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