Australian Dollar Rises with Risk Appetite but is Vulnerable to Fresh U.S.-China Fracas, NAB Says

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- AUD lifted amid recovery in risk appetite on Fed bond buying. 

- But prospect of U.S.-China trade deal appears to be fading.

- NAB says talks are key to the next 2 cent move in AUD/USD.

- Failure of the talks would burst the AUD's bubble, says CBA.

- At a time when domestic newsflow remains a drag on AUD.

The Australian Dollar was riding high Wednesday amid a recovery of global risk appetite but the antipodean unit is said to be vulnerable to losses in the days ahead because domestic and international risks to the currency are building. 

Australia's Dollar was lifted alongside other so-called risk assets Wednesday after the Federal Reserve said it will take action on mechanical faults in interbank funding markets that have stoked unease among policymakers and analysts in recent weeks. The proposed actions will see it reverse the balance sheet 'unwind' that lift the U.S. currency last year by effectively draining Dollars out of the U.S. and global financial systems. 

However, the announcement came just days ahead of trade talks between the U.S. and China that it is hoped will avert an October 15 and December 15 increase in American tariffs on Chinese goods imports. Analysts say the Aussie will rally sharply if a deal is reached, although prospects of an agreement appear to have been waining through the first half of the week and some analysts are warning about the impact that failure will have on currency.

Above: Australian Dollar performance Vs major rivals Wednesday. 

"The fate of the upcoming ChinaUS trade talks promises to be pivotal to the next two cents move," says Ray Attrill, head of FX strategy at National Australia Bank (NAB). "An increase in US tariffs is scheduled to kick in on October 15th (i.e. the lift from 25% to 30% on $250 bn worth of China imports). If this occurs, and China proceeds with retaliatory measures then, more likely than not, USD/CNY will push above its early September high (7.1876) shortly thereafter. Under these circumstances, AUD/USD will probably fall through last week’s low."

The U.S. State Department said late on Tuesday it will impose visa restrictions on a number of Chinese officials who, it's claimed, are involved with alleged human rights abuses in China's Xinjiang province. There's been repeated allegations that China is detaining members of minority populations and imposing "draconian controls on expressions of cultural and religious identities". 

Tuesday's visa ban follows a Monday decision to add 28 Chinese governmental and commercial organisations to its 'Entity List' in relation to the same allegations. The Commerce Department says those firms are involved in the Xinjiang controversy and has forbid exports to them, of items subject to the Export Administration Regulations (EAR). Both announcements were seen by the market as something that could complicate the path toward an agreement that at least temporarily ends the trade war. 

Above: AUD/USD rate at hourly intervals, alongside GBP/AUD rate (orange line, left axis). 

"In our view, a material breakthrough in US‑China trade talks is unlikely because of severe structural differences between the two countries," says Elias Haddad, a strategist at Commonwealth Bank of Australia (CBA). "As such, downside risk to global economic activity will remain high and further undermine AUD/USD and NZD/USD. Still, a partial US‑China trade agreement cannot be ruled out. If this pro‑growth scenario materialises, AUD and NZD would rally."

China has said it's open to discussing some of the issues this week but not all of them, while President Donald Trump has said he's only interested in a large deal that presumably covers all of the bases. This could mean the two sides are on a collision course with each other and that next week will usher in a fresh increase of U.S. tariffs and even more losses for the China-sensitive Australian Dollar. 

Australia's largest trade partner is China and its currency is substantially underwritten by an international trade in growth-sensitive commodities so it tends to trade like a proxy for the Renminbi as well as sentiment toward the global economy. Both those things would be adversely impacted by an escalation of the trade war that's already led to slower growth the world over. 

Above: AUD/USD rate shown at daily intervals, alongside GBP/AUD (orange line, left axis). 

"If, instead, we see an extended truce on new tariffs, China continues to buy more agricultural imports and CNY holds beneath recent highs, short covering gains in AUD/USD back onto a 0.68 handle are likely. A move through 0.69 is possible if the USD softens on such a risk-positive development," says NAB's Attrill. "There is no escaping the at-times overwhelming influence of the USD side of the AUD/USD equation. If the AUD is to undertake a material recovery in coming quarters, it will have to be in the context of a weakening USD."

An end of the trade war might offer the global economy scope to heal itself, eventually enabling central banks outside of the U.S. to not only stop cutting interest rates, but also to someday lift rates. That's widely hailed as something that would put a stop to the 18-month long rally in the U.S. Dollar and concurrent decline of currencies like the Aussie and Kiwi Dollars. Both of the latter have fallen by double-digit percentages in the last year and a half. 

Putting a stop to the relentless decline of the market estimates for the Reserve Bank of Australia (RBA) cash rate over coming years will also be key to any recovery in the Australian Dollar. Those estimates, or expectations, fell even further on Wednesday after Westpac said its barometer of consumer confidence fell to its lowest level for more than four years in October despite the RBA having cut the cash rate three times already this year. 

"Australia’s consumer sentiment index will continue to weigh on Australian interest rate futures because the RBA’s main domestic concern is the outlook for consumer spending. Australia’s OIS curve is pricing a 45% probability the RBA cuts the cash rate by 25bps in November. CBA Economics project the RBA to cut the cash rate by 25bps to 0.50% in February 2020. Expectations for more RBA rate cuts remain an important drag for AUD," says CBA's Haddad. 

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