Aussie Smack Down

The dramatic sell-off of the Australian dollar is the latest of a series of price developments that have surprised the market. The sell-off in JGBs, which appears to have stabilized, has seen 10-year yields in Japan nearly double, despite the BOJ's commitment to buy 70% of the new supply. The sharp decline in gold prices has taken place despite what was purported to be a debasement of paper money. In addition, there has not been a tsunami of capital flooding the emerging markets. Emerging market equities have under-performed the developed markets despite the stronger growth prospects.

The Australian dollar was the market's darling. It was an accessible, even if not perfect way, to get exposure to China and its vociferous demand for commodities.  It was one of the few triple-A rated countries left standing after the financial crisis.  Its interest rates were relatively higher in an environment in which there was a clear thrust toward securing yield.  Central banks found the Australian dollar an interesting, albeit limited, candidate to help diversify reserve flows.  Almost three dozen central banks reportedly have Australian dollar exposure in their reserve holdings.

The Australian dollar has fallen out of favor in dramatic fashion.  It has eclipsed the yen as the weakest major currency this month, falling nearly 5.5% against the dollar.   It briefly dipped below $0.9800 for the first time in eleven months.  

In the falling market, the Aussie's negatives are highlighted.  Softer Chinese data, weak commodity prices, official projections of a larger budget deficit, weaker domestic growth, expected lower inflation, and anticipation of future rate cuts may have all played a role in souring sentiment.  Add in some bearish comments from hedge funds, you have a run of sorts on the Australian dollar.   

Despite the Australian dollar's decline in recent weeks, there was still a substantial gross long position in the CME currency futures.  The last CFTC report covered the week to May 7.  The gross long Australian dollar position (61.5k contracts) was the largest among the currency futures, save the Mexican peso.  In fact, this Aussie position was nearly as large as the gross long yen, sterling and Swiss franc positions combined.  

What we have seen is a likely capitulation trade by stale longs.  Hedge funds and momentum traders appear to have exerted the squeeze.   Technical factors warn that the market is getting over-stretched.  In addition, the Australian dollar has come down to test an important trend line.  It is drawn off the October 2011 low and the June 2012 low.  It is found now near $0.9815.  While taken out on an intra-day basis, the Aussie is now back above it, with the help of soft US data, including a larger than expected decline in consumer prices.    

To be sure, we expect the Australian dollar to trend lower over the coming months, ahead of the September election.   The weakness of the Australian dollar takes some pressure off the RBA to cut rates in June.  The most likely scenario, it seems, is another rate cut before the election and a rate cut afterwards (i.e., a rate cut in Q3 and Q4).  Other central banks are unlikely to be deterred by the Australian dollar's weakness from diversifying reserves.  Arguably, their purchases seem to affect the pace of the move not the underlying direction