The Pound is currently breaking through a key ceiling against the Australian Dollar, but could the rise be hampered by an improving outlook for the Aussie?

At the time of writing the GBP/AUD exhcange rate is up at 1.7797, having been as high as 1.7815 earlier in the day - its best level since September 2017.

The gains are just the latest extension to an uptrend that has been in place since September 2017; and we are now looking to see if the exchange rate can move back into territory seen during the infamous Sterling collapse on the night of the EU referendum.

Sterling has been aided higher by news suggesting the U.K. and E.U. are close to moving on to the issue of the future trading relation which should help dispel uncertainty for businesses and traders.

From a technical point-of-view, the news has propelled the Pound higher in most of its key pairs, but it has seen the Pound-to-Australian Dollar exchange rate that is almost break out above a key glass ceiling level between 1.76-1.78 (see chart below).

A successful breakout above this resistance zone would see the exchange rate enter 'open ground' above, and, according to our previous technical analysis, probably climb to a target at 1.8000.

Indeed the fact that it has already tested 1.7800 would be confirmation of a continuation higher, according to our previous week-ahead analysis.

Our choice of 1.8000 as a target is merely due to its being a major round number and prices sometimes stall or reverse at these key levels.

Major round numbers are often convenient places for traders to take profit, resulting in an increase of 'supply' around them and, therefore, often weakness.

However, it is possible too that the pair may move even higher to 1.8400, for example, which is just under the 200-week moving average at 1.8435.

Major moving averages are not just indicators of long-term value but also dynamic levels of support and resistance, which means the exchange rate often stalls, bounces or reverses after touching them.

Momentum is moving strongly higher (circled), as measured by MACD, supporting the bullish forecast.

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Australian Outlook Improving: Could this Place a Cap on GBP/AUD?

One important caveat to our forecast is supplied by ANZ bank who suggest further downside for the Aussie may be limited - thus potentially restricting upside for GBP/AUD.

Recent Australian Dollar weakness has been due to falling inflation expectations due to stubbornly low wages, despite the aid of low unemployment.

Inflation drives interest rates by informing central bank policy, which is tasked with keeping inflation within bounds, and central banks respond to rising inflation by increasing interest rates, so as to bring inflation back under control again.

Interest rates, in their turn, impact on currencies as foreign investors tend to prefer parking their money in countries with higher interest rates where they can earn more interest on their capital - notwithstanding an acceptable level of risk.

Thus higher inflation leads to higher rates, which in turn leads to higher inflows, more demand for the currency and a stronger currency.

Another way of measuring inflation expectations is to use bond yields, which when compared to two countries can help indicate the direction of the exchange rate.

"The AUD has been the weakest performing G10 currency of late, driven by the collapsing yield differential between Australia and the US that followed disappointing wage and inflation data," says ANZ Analyst Giulia Specchia.

But although downside for AUD/USD may be limited due perhaps to US factors what about the Aussie versus other currencies?

There are signs inflation may start to rise in Australia, helping the AUD with it.

"At current levels, however, we expect any downside from yields to be limited. Business sentiment is at an all-time high, growth is solid and the unemployment rate is on a downward trend," says Specchia.

The Australian central bank (RBA) has been neutral about what it will do with interest rates but Bank of America Merril Lynch (BofAML) Analyst Tony Morris thinks they are not representing improving conditions appropriately and sees a higher probability of them raising rates rather than lowering them.

"Domestic factors may provide some near-term support to AUD. As argued above, RBA pricing looks stretched for a central bank that is still more likely to shift to a tightening than easing bias. Moreover, any positive news on consumer spending in the GDP report is likely to support AUD through a rise in front-end rates. As such, we expect AUD depreciation to stall until a slowdown in China becomes more evident," he said.

Rising Risk Appetite

Another source of strength for the Aussie could be improving investor sentiment due to the general upwards trend of global growth which is expected to push up investor appetite for risky assets, such as those in emerging markets, like China.

The Australian Dollar has historically closely reflected rising investor risk appetite due to its close trading relationship with China, yet ANZ notes how the Aussie has recently temporarily underperformed risk appetite compared to previous periods.

The inference is that the Aussie will start to 're-right' this temporary divergence and 'catch-up' with rising risk appetite, leading to gains for the currency.

"Notably, the AUD’s performance against other broader-risk betas and against the liquidity expansion of H2 2017 has been atypical, with it drastically underperforming risk (Figure 10). We don’t think this is likely to continue, and see the potential for a correction higher of the residual undervaluation," says Spechia.

A Spoiler To Bullish GBP-AUD Outlook?

Despite the more positive outlook for the Aussie, we are not so certain that it will be enough to prevent GBP/AUD from rising substantially higher.

Brexit risk is such a heavy weight on the Pound that if it were to ease substantially Sterling would be expected to rise, even against currencies which were themselves appreciating.

In comparison to a major breakthrough in trade talks, the drivers for the Aussie are not nearly as significant and so we doubt they will be enough - bar a shock data release - to prevent more upside from evolving from a deleveraging of Brexit risk premia.

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