Why the Aussie Dollar Rally Could Abruptly Reverse


Not much to report on in the markets overnight, folks. Stocks went back a bit, gold went up a bit. Oil went nowhere, and the Australian dollar pulled back.

In other words, a whole bunch of noise, with no real communication. A bit of a yawn, really.

One market that has caught many by surprise recently (including me) is the Aussie dollar. After bottoming below 70 US cents earlier this year, it is now trading around 76 US cents.

In this age of currency wars, a strengthening currency is not a good thing. Clearly, Australia is losing the war for now. And officials at the RBA don’t seem too concerned about it. They interpret it as a sign that our economy is doing well, and that there is foreign demand for Aussie dollars.

This is true. Everything is relative in this world. And, relative to other major economies right now, the Australian economy doesn’t look too bad.

The problem with this type of analysis is that it doesn’t take into account the attention span of global capital. What I mean is that while Australia looks good to global capital now, that could change drastically in the coming months.

And, if it does change, the Aussie dollar rally will abruptly reverse.

As you can see in the chart below, the Aussie dollar bottomed in January this year. But then China attempted another round of stimulus. If you recall, their total credit growth for January hit an all-time record, with new credit expanding an incredible $525 billion.

Source: StockCharts
[click to open in new window]

However, Chinese credit expansion in February was the weakest in years. The surge in January was an aberration. While this should be a red flag for the Aussie dollar bulls, it clearly wasn’t.

If you look at the chart again, the Aussie dollar surged in early March and kept going. This was on the back on successive attempts by the world’s major central banks to communicate that global monetary policy would remain very loose.

In other words, the ‘risk on’ trade was back on. The Aussie dollar loves such conditions.

Meanwhile, the fundamental drivers of the Aussie dollar’s value remain weak. Despite the best efforts of China to revive its housing boom, the recovery has only been in the main ‘tier one’ cities.

Perhaps that’s the reason behind the stalling of the iron ore price in recent weeks. This is worth taking note of, because the iron ore price is a good barometer of Australia’s China-related prospects. And they continue to look weak. From the Financial Review:

China’s reliance on credit growth to meet its economic targets, rising debt levels and poor policy coordination have prompted Standard & Poor’s to become the latest ratings agency to cut its outlook for the country.

 S&P held its credit rating for China at AA- but revised the outlook to negative from stable and said the rebalancing of the world’s second biggest economy was “likely to proceed more slowly than we had expected.”

But the ‘risk on’ mindset of global capital is ignoring this for now.

Instead, they see Australia’s relatively strong economic performance — and relatively high interest rates — and figure that their money is safe here…for now.

But the ‘strong’ economic growth is purely due to activity resulting from the housing boom. And while there are no signs of a collapse in prices happening anytime soon, there are indications that the best of the boom is behind us.

House price growth is slowing in the major cities of Sydney and Melbourne. There are increasing warnings about apartment values, as a glut of properties come onto the market.

Credit conditions are tightening as banks need to conform to regulations and strengthen their capital bases. All bank share prices are in noticeable and long term downtrends, which tell you that credit growth, now and in the short term future, will be subdued.

So, in the next few quarters, I’d expect to see the growth contribution from housing-related industries (not just construction, but sectors like finance and real estate) to begin to wane.

The Aussie dollar will sniff that out before you hear about it though, so don’t wait for the headlines.

Greg Canavan,
For The Daily Reckoning


Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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