Little Aussie Battler

I love watching the currency market - the most liquid market in the world. But even the multi trillion dollar a day FX market has struggled to cope with the financial crisis over the past couple of months.

Those who know me will know that I was very bearish on the AUD early this year but there is no way I expected such obliteration. I was calling 80c on AUD/USD by the end of 2008 but now all bets are off. This thing wont recover until confidence is restored in the credit markets around the world and expectations for global growth rebound. We hit a high of 0.9850 vs USD earlier this year and reached a low just above 0.60 last week.

The AUD has fallen off a cliff against most majors even more against the JPY. It hit high of 107 yen to the Aussie twice during 2007 and hit a low last week of 55. This is a massive drop in such a short time frame, so where do we go from here?

Australia has a vast supply of commodities which will still be in solid demand from China, India etc. The problem is that the world perceives that such a dramatic slowdown in the west will drag the economies of these 2 nations down with them. The perception of the world and markets is that when the US consumer sneezes, the rest of the world catched a cold... This perception combined with Credit Crisis fears has seen investment dollars from around the world repatriated into Yen and USD low risk short term government issued notes. One of the more popular Japanese investments - the "carry trade" was to sell JPY and buy AUD unhedged and enjoy the benefit of rolling interest differentials (pay 0.5% on JPY borrowing and receive 7% on AUD deposits). The panic to unwind these carry trades and repatriate funds to Japan seems to have impacted the AUD substantially.

BUT, where we go from here, depends on whether you believe the emerging economies have decoupled from the US. Here's a good article on decoupling from the Economist. The latest retail sales in China show a 23% annual growth rate, and they are still on track for 8% GDP growth this year, so this argument is quite conceivable. Although manufacturing has slowed, the decoupling theory doesnt suggest China, India etc will be immune to the slowdown, it just suggests the effect wont be as bad as many think.

Fundamentally, I think AUD is a great buy anywhere near 60c vs USD or 60 vs JPY. Interest rates in Australia have been cut dramatically and expectations are for us to see a cash rate of 4.5% early next year. This is still a good premium over the near zero rates in US and Japan. We will see a rebound but when?

Markets can stay irrationally priced for long periods of time, especially in uncertain time such as now. Fundamentally the AUD was sound and had a positive carry in 2001,2 but hit a low of 47c against the USD. I like the AUD as a buy, but I'd be reluctant to jump in just yet, the trend lower is still strong and we may see even better levels to buy over the coming months.

First - we need stability in the currency. Stability will build confidence and many investors who were burnt by the 40% drop this year will be reluctanct to jump straight back in. Once bitten twice shy. This stability will return when liquidity returns, which will happen once this global uncertainty dissipates.

So we may go lower in the short term, the trend is certainly down for the AUD in all timeframes but we are 10% off the lows now and it will be interesting to see where November takes us.