Pairing strength against weakness

One of the core principles in trading is to pair strength against weakness, a weak currency with a strong currency. It is a way of increasing the odds of a clear direction. The AUDCAD pair is a good example of two countries at slightly different stages. These different stages  can create a medium term divergence that can create a clear directional bias for . Below is the weak and the strong currencies as well as the key risks to this outlook.

Strength for the AUD

The last RBA minutes showed that the RBA had been considering a 40 bps rate hike at their last meeting as well as the 25 bps hike they implemented. The RBA have recognised now that they need to tackle inflation quickly as it is more serious than they had originally thought. This means the RBA are now at the start of a rate hiking cycle ( at 0.35%) to bring down inflation. This boosts the AUD medium term as interest rate moves higher increase demand for the AUD. The latest wage price index data was below forecast, but remember if something can’t sell off on bad news that can be a sign it won’t sell off at all.

Weakness for the CAD

The BoC is in a very different place. Interest rates are at 1.00% and they increased their neutral rate to 2.5% from 2.25%. Their April hike was a 50 bps rate hike in response to high inflation and they remain committed to tackling inflation as they also start a passive QT from the end of April. The issue with the CAD is not that the currency is ‘bearish’, but that a lot of this good news has already been priced in. In January this year markets became too aggressive over CAD strength on coming rate hikes and so much of that strength unwound. Once again CAD strength looks stretched, so a retracement in the CAD looks possible even as the AUD gains. 

Think of it like this – the AUD is just turning bullish after a long period of flat interest rates. The CAD’s bullish expectations look like they are starting to peak. So, this is why AUDCAD upside could be due over the next few weeks into the next RBA meeting. 

The key risks of pairing strength against weakness here.

All outlooks have risks. The key risks with this one are numerous. They include, but are not limited to things like the COVID outbreak in China, the price of Iron ore, oil,  and overall risk sentiment. The AUD gains when China is strong, Iron ore prices are high, and risk sentiment is positive. High oil prices usually support CAD since it is a major oil exporter. So, there are a myriad of risks to navigate. 

The AU10y-CA10y bond yield spread is pointing to higher prices and risk can be easily managed underneath 0.89000. So, although there are risks, they can be managed. Pairing strength against weaknesses a key concept I teach every day.