Australian Dollar: Time To Pick A Bottom?

With U.S. markets closed for Memorial Day and U.K. markets closed for their Spring Bank holiday, yesterday was very quiet in the foreign exchange market. While we know that everyone is eager to find out where USD/JPY is headed, we have spent a lot of time writing and saying (CNBC, BNN interviews) how the currency pair could drop to 100 but losses should be limited because the currency pair should still be in a long term uptrend. So instead we want to take this opportunity to discuss the Australian dollar – a currency that has dropped more than 8% in the past few weeks.

In early April one Australian dollar was worth as much as 1.05 U.S. dollars but fast forward 6 weeks and now one A$ is worth less than 0.97 U.S cents. This reversal of fortune has come swiftly and aggressively for Australians who have seen their purchasing power evaporate. Unfortunately, Aussie weakness has not been limited to the greenback as the currency lost more than 7% of its value against the EUR, JPY, and GBP over the same period.

The Australian dollar had been hit from all sides over the past month. The selling started with weaker Chinese data, which was followed by weaker Australian data. The Reserve Bank responded with a surprise rate cut and shortly thereafter the U.S. dollar started to rise, causing commodity prices to plunge. Last week we learned that the Chinese manufacturing sector slowed even further, raising concerns that this vicious cycle could start all over again, driving the AUD to fresh lows.

From a fundamental and technical perspective, we believe that the AUD could be poised for further losses:

1. The Australian Dollar is STILL Overvalued

According to purchasing power parity, the Australian dollar is still overvalued. Even after the 8% decline in the currency, the OECD’s measure of purchasing power parity has the AUD overvalued by 29% against the U.S. dollar. Although the Economist’s Big Mac index puts the AUD’s overvaluation at only 4%, it is still expensive. While currencies can and will deviate from their fair values for long stretches of time, from a purchasing power parity perspective, the Australian dollar is not cheap.

2. Renewed Chinese Growth combined with Lower Commodity Prices is Bad News for Australia

If the Chinese government’s official data confirms HSBC’s report that manufacturing activity contracted in May then Australia, which counts China as its largest trading partner could be in for some serious trouble. The double blow of weaker Chinese growth and lower commodity prices could put significant pressure on the Australian economy over the next few months. In the past, high interest rates helped the Australian dollar shrug off lower commodity prices but now with the RBA maintaining a bias to ease and the AUD falling sharply, foreign inflows may be insufficient.

3. Charts Show Limited Technical Support

The following chart shows how there is very little support in the AUD/USD until 95 cents. The more significant support level is at 0.9385, a former breakout point. The pierce below the 50-month SMA is also fairly significant because it opens the door for the move lower.


The Light at the End of the Tunnel…

Eventually, the decline in the AUD/USD will come to an end and that may happen sooner rather than later. All that's need to stabilize the Australian are a few positive economic reports. The recent rate cut by the RBA and the decline in the currency provides underlying support for the export dependent economy. Since many Australians shop from abroad it will keep demand domestic while at the same time making Australian goods more attractive, offsetting some of the pain from lower commodity prices. Tourism could increase and the housing market could benefit from external demand.

We would prefer to buy strength rather than weakness because when the AUD/USD recovers, the snapback could be strong. As shown in the following chart, if the AUD/USD rises back above 0.9840, the trend has turned and we could position for a stronger recovery.

Remember, at 2.75%, Australia still offers higher interest rates than other parts of the world. Also, the primary reason why the RBA cut interest rates was because they were worried about the damage that a strong currency could do the economy. Now that the AUD has fallen more than 8% from its April high, the bar is high and the economy would need to deteriorate significantly for the RBA to consider another rate cut.