The AUD is trading at its highest level in 10 months supported by recovery hope, the recent rise in global equity and commodity markets and RBA rate hike speculation. The RBA elected to hold interest rates steady for the fourth month in a row in August and shifted to a neutral bias signaling its rate cutting cycle has ended. The RBA meet on Tuesday, September 1st and are widely expected to hold rate policy steady at 3%. The key issue is whether the RBA takes a cautious monetary policy stance or begins to lay out the timeline for coming rate hikes. RBA Governor Stevens has said that the decision to raise rates will need to be balanced against the risk of inflation versus prematurely killing off confidence and demand. Late last week, RBA watcher Mitchell wrote an article which concludes that he RBA may hike rates in October. Analysts at J.P. Morgan Chase also expect the RBA to hike rates in October citing improving Australian economic data. Recent Australian economic data shows improvement in consumer and business confidence, better than expected employment data and an unexpected rise in Q2 CAPEX spending. Q2 CAPEX spending unexpectedly rose by 3.3%. These reports suggest that the Australian domestic economy has come out of the financial crisis with limited damage.

On August 14th, RBA Governor Stevens said that the central bank will have to raise the benchmark interest rate from its emergency level at some stage as the economy rebounds from global recession. Stevens said a more normal level for the benchmark rate is a good deal north of 3%. Stevens went on to say that economic conditions in Australia have been stronger than expected with consumer spending and exports showing resilience. According to Stevens, the US economy is nearing a turning point and the Chinese economy continues to strengthen. Since Stevens made these statements China has elected to take action to curb lending and the Shanghai Index has fallen more than 14%. US economic data has shown stabilization in housing and manufacturing but consumer confidence remains weak and unemployment is expected to continue to rise. Fresh doubt about the global recovery may encourage the RBA to maintain steady policy.

The major risk to Australia's economic outlook is the uncertain outlook for the Chinese economy and world recovery. China is Australia's major trading partner. A slowdown in China's economy will hurt Australia's growth outlook. Another cause for concern is the Baltic Dry Freight Index which is a measure of demand for shipping commodities. The Baltic Freight Index is trading at 11 week low. This could be an indication that global demand for commodities is weak which may threaten the global recovery. The decline in the Shanghai and Baltic Index's may give the RBA pause when considering the timing for hiking interest rates. In addition, the RBA may express concern about AUD strength. The RBA has been intervening over the last few months selling AUD partly because of concern that the strength of the AUD may choke off recovery. AUD strength is a double edged sword. AUD strength may make Australia's exports less competitive but also helps to curb inflation. Inflation is not yet a concern for the RBA and this may delay the timing for a RBA rate hike. It is not clear if the RBA will comment on the AUD. If they do comment on AUD strength it would be a minor headwind for the AUD.

The trade will be looking at Tuesday's RBA meeting for clues to the potential timing of an RBA rate hike. If the RBA elects a hawkish bias and gives hints to the timeline for rate hikes the AUD should continue to rally. If the RBA takes a more cautious policy outlook the AUD may see some light long liquidation selling pressure. Either way, Australian futures markets are looking for a 50 basis point rate hike before the end of the year. The general consensus is that the RBA will be the first major central bank to hike interest rates as the global economy recovers. AUD downside should be limited by RBA rate speculation. Look for RBA to hold monetary policy steady Tuesday and refrain from setting a timeline for hiking interest rates.

AUD put in an impressive performance Monday rallying despite falling commodity prices and weaker equity markets. Part of the rally may be linked to the Japanese election and the DJP landslide victory. The DJP is expected to increase spending to boost growth. This could be positive for the Asian growth outlook and Australian exports. Also, the Fed's Dudley pledged that the Fed would not be removing stimulus any time soon. If stimulus is removed too soon the economic recovery may fade. Most likely the breakdown in the AUD correlation to commodities and equities in Monday's trade reflects thin summer markets, month end flows and a short squeeze sparked by report of stronger than expected Chicago PMI. The true test will come in September which has historically been a bad month for equities.

Expect AUD support at 8239 the August 27th low with resistance at 8525 the September 22nd high.