The dream (nightmare) is over for the Australian dollar

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May was a big month for me – I made some big calls which, as we enter June, I am even more convinced of.

The first big call was the question of whether or not Australia might be facing a recession which I posed on May 4th. Here is a link to the full piece but this is how I summarised the situation:

So in the midst of a mining boom the idea that Australia could enter recession is a very left field call and the Reserve Bank is going to everything in its power to ensure this doesn’t happen. But with the Government tightening their belt along with the Household sector the risks are rising that for the first time in a generation Australia heads into recession.That means that rates will probably still head substantially lower and hopefully take the Australian Dollar with them.

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The second call was that the Aussie dollar was headed to 90 cents against the US dollar which I made on May 9th. Here is the link to the piece but my summary was:

… just like last year when I formed the view 3 year swaps were going to fall precipitously so I am now starting to get the tingling that the Aussie Dollar is actually had its time in the sun and will, over an extended period head back toward 0.9000 against the USD. As I say this is a big picture long term view and I am working on my thoughts so this is just a warning about the Panglossian expectations of Aussie Dollar pre-eminence.

A prescient warning as the Aussie dollar fell from the 1.02 region at that time to sit at 0.9728 as I write.

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The key reason I wanted to recount both these warnings is to highlight that since then things have deteriorated, both domestically and globally.

The Australian economy is clearly weakening, the big miners are talking about putting off new projects, the survival of big retailers is being questioned openly, housing price falls continues and the global economic backdrop is deteriorating with bank runs in Spain, ECB officials questioning the future of the euro publicly and China is also clearly weakening in terms of the economic outlook.

So the macro backdrop for the Australian dollar is clearly deteriorating and I wonder if their is a tipping point where investors eventually bailout of excess long Aussie dollar positions because, as Bill Evans said in his note calling for the RBA official cash rate to 2.75%:

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The contrast with those earlier periods the implied stance of policy should also take into account the level of the Australian dollar. In 1997 the AUD/USD was around 68¢; in 2001 around 50¢ and in 2009 around 70¢. Clearly the AUD was providing a much more complementary stimulatory support for the economy than in current circumstances where, despite recent weakness, it is still around 98¢.

He means that the level of the Australain dollar implies rates need to do more work, but equally it is a warning to Australia dollar bulls that things might change fairly quickly should the outlook darken further:

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And I guess that is the question. The above table of charts is of the Citibank Economic Surprise indices for a number of countries/markets. What you can see here is that there has been a clear deterioration in the economic data relative to what the market and the punditry had been expecting. The nature of these types of indices and why they look to be mean reverting is that people adjust their expectations in line with the past data flow. So they swing from being sanguine to pessimisitic and back in an endless cycle.

You can map equity moves against these indices and the Australian dollar works reasonably well also (at least enough to have this in the tool kit). But the key point here is that the data has actually been printing weaker both on expectations and in actuality.

This is never a good backdrop for the Australian dollar or commodities and is generally a positive for the US dollar so we end up with a feedback loop where the Australian dollar in particular has a high beta to what’s going on.

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Which brings me back to the Australian dollar outlook:

Short term and technically the low yesterday was a cracking point to pull up and super important in the context of the next leg higher or lower. As you can see in the chart above, the Aussie’s low was the same level as the low back in December 2011. A break (particulalry a weekly close) on the technicals opens up the very important support zone around 0.9430ish which was the 2011 low and the range high in 2009/10 before the break to the new range which you can probably call 0.95/1.10. But a bounce could gets us back to the recent highs around 0.99 again. But the bias is lower.

So what about the rest of the tool kit.

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Interest Rate Differentials: The chart below shows the collapse of the Australian versus US 2 year bond spread which is on our 5 drivers in the toolkit. This is reflective of the weakness in the Australian economy we have been talking about for a long time now but to which many pundits have more recently become convinced:

While this is not a lock step trading tool it certainly undermines Australian dollar’s strength against the USD.

Global Growth/Commodity Prices and Investor sentiment: we’ve talked about these above with the Surprise index and the CRB index down a whopping 10.78% last month reflecting not only the concerns over Europe but also with regard to China and global growth. Technically, I reckon the CRB is headed towards 250 as you can see in the chart below:

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The US Dollar: at times of trouble, and in the absence of any other asset, the USD benefits from its safe haven status. So it is that it has broken its range top for the past 18 months in the course of May and looks biased higher. By the simple fact that the USD is on the other side of the Australian dollar and commodities, when it is strong it places an amplified downward pressure upon the Australian dollar even if it can appreciate against the euro, as it is at present.

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My expectation is that the USD will continue to improve over the month or months ahead.

So all up, the Australian dollar has pulled up at the end of May at a very important technical level – but the fundmantals and the key drivers in our tool kit have turned against it.

There will be bounces along the way but I retain my view that the Australian dollar is heading lower in time, substantially so.

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Have a great day

Gregory McKenna

www.twitter.com/gregorymckenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.