In my previous article I said it was possible to see the Fed drop the “extended period” language by the June meeting and see a move on interest rates occur by the end of the year. However, in looking over the minutes of the last FOMC meeting in March, I don’t believe the Fed will change anything in the language at the June meeting although we still could see a move on rates in the 4th quarter.

As I also mentioned, there appears to be a pretty strong dis-inflationary trend happening at the moment, especially when you look at core CPI. While it rose just 1.3% in the year to February, the measure increased at a 0.8% annualized pace in the 6 months to February, less than half the 1.9% increase seen in the prior 6 month period. In the last 3 months, core has risen at an annual rate of just 0.1% which, for Central Banks, is scary low.

At this point, I prefer to wait and see what happens at the Jackson Hole meeting in August. It was there in 2007 where economists seemed to reach a consensus that the Fed should begin to ease, with Harvard economist and former NBER chairman Martin Feldstein leading the charge.

The Real Trade

If you want to play a trade on diverging interest rate momentum, the best trade (other than USD/CAD) would appear to be AUD/USD. Futures markets are quite convinced that the RBA will continue to tighten policy going forward, with some believing rates will go as high as 5.25% by next March. The only thing that could stop the aussie’s upward momentum would be if the market suddenly grew risk-averse and bought dollars as a source of safety, something that doesn’t look set to happen especially with the Fed on hold.

Writing on Bloomberg, Michael Heath noted that the RBA’s statement drew attention to Australia’s rising terms of trade, a concept that measures how much a nation receives for exports relative to what it pays for imports. Overseas shipments are increasing in value as Chinese demand spurs prices of Australian iron ore and coal, shifting the growth engine of the country to the resource-rich west.

“When they start discussing the Australian economy, the first mention is on the terms of trade,” said Brian Redican, senior economist at Macquarie Bank Ltd. in Sydney, referring to the Reserve Bank of Australia’s statement. “That will be a larger stimulus to the economy this year than the fiscal stimulus was last year,” he said.

How To Trade It

As you can see on the chart, the 80.9 Fib level was the last place to act as resistance, so what I plan to do is to buy the pair if price retreats to that level (.9245) and hold it to the last swing high at around .9400. I have about 50 pips as the stop because that gives me a 3:1 reward to risk ratio, which is what I prefer as the best way to control risk. This way, I can still be positive even if I win only 1 in 3 trades and I can break even by hitting just 1 in 4. And should this trade fail to hold, I would look at the 61.8 Fib level as the next entry point.

When you really think about it, if the Canadian dollar can hit parity with merely the threat of an increase by the Canadian Central Bank in June, there’s no reason to believe that aussie can’t do the same as the RBA remains on its tightening cycle.

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