AUD/USD Forecast: Risk appetite and dollar weakness align for breakout

• DXY losing haven appeal despite ongoing Iran tensions
• AUD/USD increasingly driven by risk appetite
• Australian Budget and US CPI may struggle to move the Aussie
• Break above 0.7283 could accelerate upside momentum

Geopolitics no longer supporting US dollar

AUD/USD may be on the verge of a bullish breakout as the US dollar loses one of the key pillars that supported it during periods of geopolitical stress over recent months.

Even with tensions in the Middle East escalating again with oil prices surging, the greenback has struggled to generate meaningful upside traction, instead sinking back towards levels that leave the dollar index threatening a fresh bearish breakout. Reinforcing the shift, the rolling 20-day correlation coefficient between DXY and Brent crude, shown in the bottom pane below, has deteriorated sharply from the high 0.9s for much of March and April to now sit at just 0.39, suggesting the dollar is no longer behaving like the energy security proxy it once was.

Source: TradingView

From a technical perspective, the DXY finds itself in a clear downtrend from the highs set in late March, more recently coiling within a descending triangle that first formed in mid-April. With the index trading beneath key medium and longer-term moving averages, along with RSI (14) and MACD suggesting downside momentum is rebuilding, the bearish structure leaves traders on alert for a potential breakdown through 97.65, putting levels such as 97.34 and 96.50 in play initially.

AUD/USD correlations send a clear message

Importantly for AUD/USD, the regime shift is taking place at a time where the Aussie is no longer trading as a yield differential play, instead behaving more like a leveraged expression of broad risk appetite and US dollar direction.

The relationship has become remarkably strong over the past month, strengthening even further over the past week. As the correlation matrix below reveals, AUD/USD’s inverse relationship with the DXY has pushed to extreme levels across multiple time horizons, reinforcing the view that broad US dollar direction is now the dominant force driving the pair.

Source: TradingView

At the same time, the Aussie’s strongest positive relationships are increasingly tied to broader risk appetite, reflected through its close alignment with US and global equities along with implied Treasury market volatility. The relationship with both US and global equities has surged to 0.96 over the past week, building on already strong positive readings across longer timeframes.

With risk appetite now the dominant force driving the Aussie, unless you see a looming rout in technology stocks which have been the key force behind the rally in equity markets, it suggests AUD/USD is likely to remain supported.

Why Australia’s Budget and US CPI may matter less  

Source: TradingView (US EDT shown)

That potentially leaves upcoming Australian data and the federal Budget later today as little more than cannon fodder for headline writers rather than genuine market-moving events. Australian budgets rarely influence markets in a sustained manner, and while flagged tax reforms may impact Australian government bonds on this occasion given it’s relatively rare to see major changes announced, the lack of relationship between AUD/USD and yield differentials casts doubt on whether it will matter much for the currency.

The same argument can largely be applied to US CPI data for April later today. With stable labour market conditions and sluggish wages growth allowing the Federal Reserve to look through any near-term energy-driven inflation impulse given it reflects cost-push rather than demand-driven forces, it raises serious question marks on whether the report will meaningfully shift the dial for the US rate outlook, and with it the dollar.

Trump and Xi may hold the key to sentiment

Instead, markets may have their eyes fixed on other factors likely to influence sentiment, and not necessarily the Iran war. Chief amongst them is Donald Trump’s meeting with Xi Jinping in China on Wednesday.

They would not be meeting unless they had wins to show their citizens, making it an event that may help underpin risk appetite at a time where sentiment appears to be the dominant force driving AUD/USD.

Even though the relationship is not as strong as it once was, for a currency that has been used as a China proxy trade for lengthy periods in the past, any improvement in sentiment surrounding US-China relations conceivably bodes well for the Aussie.

Technical setup favours further Aussie gains

Source: TradingView

There’s not much to dislike about AUD/USD right now from a technical perspective for bulls. The price remains in the uptrend from the lows struck in late March, marking what for now looks like the nadir in sentiment surrounding the Iran war and its impact on the global economy and earnings. That uptrend has now been tested on several occasions and held every time, including last Tuesday when the RBA delivered what was arguably a less hawkish rate hike than markets had priced in beforehand.

Since then, the price has continued to grind higher, culminating in a bullish engulfing candle last Friday before a fresh closing high was printed on Monday.

Overhead, the June 2022 swing high at 0.7283 is the key level to watch, with a break above opening the door for a run towards 0.7460, a level that previously acted as both support and resistance during the prior bearish trend from the highs struck in the early stages of the COVID pandemic.

Momentum indicators are also turning higher, adding to the sense that a bullish breakout may not be far away. Bearish divergence between RSI (14) and the price that was previously warning on reversal risk has been replaced by renewed upside strength, leaving the signal favouring further gains, especially as it’s not yet overbought. MACD has also confirmed the move, reaccelerating away from the signal line while holding in positive territory.

Should AUD/USD be unable to break above 0.7283 and instead slip below the March uptrend, it would open the door for fresh short setups to be considered, allowing positions to be established beneath the uptrend with either the trendline or 0.7283 used for protection. On the downside, 0.7200 would be the initial target, with a deeper pullback towards 0.7100 possible beyond that.