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Do you remember what we said at the start of the year about the Australian dollar and re-iterated in March? See here – We have been alerting our readers’ attention to a cracking opportunity that we thought was forming to bet against the Australian dollar.

For many years, conditions were favorable for the Aussie, but global changes over the last 12 months has changed the scenario dramatically over the last year. Our call has in fact taken the top slot this year in the Forex market as you can see on the table below. Against the pound, we had a target of $1.75 and this was almost touched in recent weeks.

With the GFC in equities ending in 2008 and QE setting off, initially, a commodity boom and yield depression, investors quickly moved into the higher-yielding Australian dollar and set in a place a near 4 year rally that caused the “aussie” to become dramatically overvalued. Flip side of course is that being a resource-rich economy, highly dependent on its exports of commodities, the Australian economy is very sensitive to global growth. An improving global picture between 20010-12 led to improvements in Australia’s GDP which pressured the central bank to increase its official cash rate and so in an environment where other countries were running ZIRP policies, so created the necessary conditions for the massive gains we saw. From a low near 0.6050 in October 2008 the AUD/USD rose to a high near 1.10 in July 2011, gaining a massive 4,950 pips on a 82% increase, an enviable opportunity for any avid spread bettor.

Between 2009 and 2011 all the stars seemed to align in its favour – China was stimulating its economy with a package aimed at boosting once again its infrastructure stock. With iron ore representing more than 50% of Australia exports and with China absorbing 30% of the country’s total exports, stimulating the Chinese economy is almost the same as stimulating the Australian economy! Secondly, the RBA started tuning its benchmark rate to the upside. From 3% in 2009, it moved it progressively higher to a 4.75% rate in November 2010. This created further upside potential for the Aussie. Thirdly, the FED was stimulating its economy by injecting massive amounts of liquidity and in the process debasing the dollar. With all these factors on the table, there could only be one direction for the Aussie.

In terms of Sterling, the same reasoning applies. The BOE was also engaged in billions of pounds of monetary easing whilst keeping its benchmark rate at 0.5%.

But, things change quickly. Global growth decelerated during late 2012 and doubts were cast about the Chinese’s ability to keeping its stunning GDP growth near the punchy 9.3% – the average rate it had achieved over a period of more than 40 years to 2011. Additionally, growth in Europe was non-existent.

This recipe brought volatility to the Aussie in 2012. With inflation easing back domestically, the RBA began a steady reversal of its interest rate direction, cutting the rate from 4.75% down to the current 2.75% – a level that is even below that seen during the financial crisis. With here trade balance also deteriorating, it was clear for us that the Australian dollar trading around 1.0235 against the US dollar and in particular near 1.4750 against the pound was an unrealistic level to say the least. We were even more emboldened by the so called “experts” calling it down to $1.35 – a level where you would have needed a mortgage to afford a coffee!!

With QE now near an end, expectations over the interest rate differential between the Australian dollar and Sterling and between the Australian dollar and its US counterpart have decreased dramatically, and which has weighed negatively on the AUD. At the same time, it has been clear since the end of last year that China is growing extensively again. The Chinese Govt seem happy to rebalance the economy towards a new 6-7% growth rate – something that is to only be expected given the increasing maturity of the economy and its move up the export value chain. The relatively newly appointed government knows they need to change to a consumer-driven economy rather than the infrastructure-driven profile of the last 2 decades. They also need to navigate the bursting of their own property bubble and this is choking economic growth.

A softer GDP growth rate emanating from China translates into decreased demand for commodities and consumer led v infrastructure focused further deteriorates demand for commodities like iron ore. It is thus not difficult   just how badly Australia can be hit. Commodity prices have been deteriorating this year with the exception of oil. And unlike what happens with gold, coal, or iron ore for which Australia is a net exporter, the country is a net importer of oil. Its oil production has in fact been declining over the past 10 years while consumption is rising. This further pressures its trade balance and acts as a drag on its currency.

Crafting all this together, we have a resource rich export dominated economy that is being hamstrung by depressed commodities whilst suffering from the high importation costs of oil. Throw into the mix rising bond yields in the UK & US so decreasing the interest rate diffs further (and the cost of holding the position),  and this is a trade that we remain happy to sit on.

R Jennings, CFA. Titan Investment Partners

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