We have the benefit of substantial volatility and heavy event risk. Any currency trader recognizes the potential in this mix. Against the backdrop of progressive fundamental developments, conditions can finally lead to significant trend development.

For the Aussie dollar crosses specifically, we will continue to monitor risk appetite trends, but there is a second factor that can significantly alter the direction and pace of this particular currency: interest rates. We know this currency to be the highest yielding of the majors and it thereby finds itself to be one of the main benefactors of a rising demand for yield – and that return also acts to dampen a negative reaction to deteriorating investor confidence that normally weighs on the ‘investment’ currencies.

This morning, we come upon the RBA rate decision, where the market’s expectations for rate cuts are wavering and the outlook has similarly grown murky. With risk trends struggling for traction ahead of the US election, this particular event risk can act as a supplementary driver for risk sentiment currency pairs like AUDUSD and AUDJPY, or it can prove the primary concern for the non-risk pairings like AUDNZD and AUDCAD.

Market Expectations

Heading into the RBA rate decision, we find that the consensus amongst economists is for a 25 bp rate cut to the benchmark rate to a 3.00 percent rate – what would be the sixth move in a year for a total 175 bps (1.75 percentage points). Specifically, 20 out of 27 economists expect such an outcome according to Bloomberg’s consensus.

However, the market is not so certain. Look at the chart below, we can see that swaps are currently pricing in only a 47 percent probability that there will be a cut from the central bank. This leaves plenty of room for surprise whether they move for a cut or not. And, we can certainly see in this comparison that interest rate expectations have a considerable influence over currency price action.

The next chart below is the 12 month interest rate outlook for Australian monetary policy backed out of swaps. This is the next level of concern for FX traders. A cut or hold is not the only means of influence (and likely not the heaviest component) to the Aussie dollar. The possibility of further cuts and the level of aggression behind this move can change the currency’s position on the investment scale. In other words, if the level of return declines; it will be far more exposed to negative adjustments in risk appetite.

The Setups

Given the potential for this indicator to generate surprise on either side of its outcome, we should look at trade setups with potential under different scenarios (primarily a hold that tempers the outlook for more cuts or a reduction that feeds the forecast from here).

Below, we see AUDUSD. This has a good wedge formation with breakout points above at 1.0400 and below at 1.0325. We should suspect that even if the benchmark rate is cut to 3.00 percent, the outlook for further easing over the coming year will remain relatively reserved. However the marginal decrease in yield potential could certainly be enough to contribute to a bearish break.

On the other hand, a hold may further diminish the outlook for future interest rate expectations and encourage short-term adjustment based on the rate consensus heading into the event. A move to the upside – though it may be volatile – will likely struggle for follow through. With the additional factors of an uncertain risk outlook (it is difficult to carry optimism and growth potential under current conditions) bulls should keep their expectations reasonable.

The AUDJPY should be treated with a similar approach as that of the AUDUSD. There is a definitive yield influence as well as risk trend approach. Here the technical levels are just as consistent between 84.50 and 79.50. Here, however there is a slightly more reserved reaction to traditional risk trends thanks to the growing concern over the Japanese authority’s efforts to devalue their currency.

If we want to get away from the confusing aspect of risk trends, we can look at Aussie pairs that incorporate similar investment currencies. AUDNZD is a good example and AUDCAD below is similarly positioned. Since these are both treated as yield currencies, we will see less resistance from concerns about ‘risk on’ or ‘risk off’ and more intensity centered on rates. Both pairs have tentatively made technical moves that suggest a reversal could develop from here, but we need the fundamentals to confirm that that will be the case.

— Written by: John Kicklighter, Chief Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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