After selling off for the past 3 months with virtually no relief rallies, we believe that the Australian dollar has officially bottomed. For the first time in 2 years, the Reserve Bank of Australia expressed comfort with the current level of interest rates AND their currency. By dropping their easing bias, the RBA set off a wave of short covering in the Australian dollar last night that we expect to continue in the weeks to come. In fact we are looking another 4% to 6% rally in the currency.

Going into the monetary policy meeting, A$ was trading near its 3 year lows because investors had been pricing in one more rate cut in 2014. According to the CFTC, there was also a significant amount of short positions in the Australian dollar so when the RBA said “on present indicators, the most prudent course is likely to be a period of stability in interest rates,” it immediately prompted short covering. For the first time in a number of months, the central bank also did not describe the Australian dollar as “uncomfortably high,” which suggests that they are comfortable with an AUD/USD exchange rate in the high 80s.

By shifting from a dovish to neutral bias, the central bank is telling the market that they aren’t worried about the recent deterioration in Australian and Chinese data as they expect the recent decline in the Australian dollar to balance growth in the economy. While the RBA still believes that growth will remain below trend for a time and the unemployment could rise further before it peaks, the central bank doesn’t feel that it is necessary to ease monetary policy further especially with inflation at the top of its 2-3% range.

Based on the rally in the Australian dollar today, the RBA’s decision to shift to a neutral bias caught every one by surprise. Having ended their easing cycle at a time when speculative short positions are near extreme highs, the central bank stands the risk of driving their currency sharply higher. Without the support of a potential rate cut, there is very little reason for traders to hold a significant amount of short Australian dollar positions especially given the negative interest rate differential with the euro and U.S. dollar.

The following chart illustrates the magnitude of previous rallies in the Australian dollar (white line) when speculative short positions (yellow line) were unwound. They ranged anywhere from 3% to 26% and since short positions are higher now than they were in 2010 and 2012, we are looking for another 5% rally in AUD/USD that would make the move from the bottom closer to the 8.5 to 9% rallies that we saw in 2012 and 2013.

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