AUD/USD: Bullish rates reversal signals US dollar downside risk

• Rising US bond yields have helped fuel US dollar strength recently
• US 2-year Treasury note futures staged a bullish reversal on Thursday, generating a signal that we may have seen the highs for yields near-term
• AUD/USD may benefit from an environment of lower US yields

Overview

If you want clues on directional risks for the US dollar, there are worse places to look than US 2-year Treasury note futures, shown in the left-hand pane in the chart below. As one of the most liquid futures contracts globally, the price signals it provides can be very informative for broader markets, especially in the FX universe.

Did we just see the highs for US yields?

Having tumbled most of October, implying higher US yields given the inverse relationship between the two, the price action this week looks potentially important. We saw the price take out long-running uptrend support on Wednesday before staging a large bullish reversal on Thursday despite another hot US inflation report.

The bounce off the 200-day moving average on big volumes delivered not only a hammer candle but also took the price back above former uptrend support, delivering a bullish signal that suggests directional risks for yields may be skewing lower. You can see that in the right-hand pane with the daily chart of US 2-year bond yields which hit multi month highs on Thursday before reversing lower.

But it’s the correlation analysis beneath the chart that I want you to focus on, looking at the strength of the relationship 2-year yields have had with a variety of FX pairs over the past fortnight. USD/JPY has a score of 0.9 with USD/CNH not far behind at 0.89, signalling that where yields have moved over the past two weeks, the pairs have almost always followed.

EUR/USD, GBP/USD and AUD/USD have experienced similarly strong relationships over the same period with scores ranging from -0.88 to -0.96, the only difference being where yields have moved, they’ve usually done the opposite.

The broader readthrough is that shorter-dated US yields have been influencing US dollar direction recently, with rising rates fuelling dollar strength. But given the bullish signal from US 2-year Treasury note futures on Thursday, if we just saw the lows, it implies we may have also seen the highs for US yields and the US dollar.

AUD/USD reverses from 50DMA

Having been among the hardest hit from US dollar strength, the prospect of lower US bond yields may help spark a reversal in AUD/USD.

Looking at the daily chart, the close above the 50-day moving average on Thursday has provided a setup for longs with appealing risk-reward, allowing for a stop to be placed below for protection.

I’m not rushing in given momentum indicators continue to provide bearish signals, but if the price tests and/or holds above the 50DMA you could enter longs targeting a push towards either .6800 or the downtrend currently located around .6830. You could also wait to see whether the price eases back towards .6700, providing another long setup where a stop can be placed beneath for protection. Targets would be identical.

One risk to consider with this trade is the potential for disappointment from China’s latest stimulus measures that will be unveiled on Saturday. Based on media speculation regarding the size of the fiscal package, expectations look modest relative to major stimulus programs of the past, creating two-way directional gap risk for AUD/USD on Monday morning.

-- Written by David Scutt

Follow David on Twitter @scutty

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