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The Australian dollar was a crowd favorite of the macro trading set last year. There were several upward explosions in AUD/USD as a result.
Up to now, the bulls have been correct — and with good reason. The Australian dollar had a long list of solid fundamentals.
But there has been a sea change in the major factors underlying the success of the Australian dollar. Due to the brittleness of the carry trade, small changes in fundamentals could have an outsized impact in the price level of the AUD/USD.
There were three strong, obvious factors propelling the AUD/USD over the last year:
- QEII inflation fears: QEII hype caused fears of massive inflation, spurring a flight away from the USD to nearly every other G-7 currency.
- Commodities Boom: Insatiable demand from China fed heavy capital flows to commodity exporters like Australia.
- Strong Australian economy: Australia weathered the financial crisis with only a minor recession (and continued to grow strongly post-crisis).
These three factors are enough to propel any currency higher.
But at least two of the reasons – and perhaps all three major reasons – for Australian dollar strength depend on the weakness of the U.S. dollar.
And now the U.S. dollar has shrugged off QEII without much lasting inflation at all. This could mean a sea change in the fundamentals facing the AUD/USD.
A sea change in the AUD/USD fundamentals
One could easily make a case that the hot commodity market was due to fears of U.S. dollar inflation. It's been the dominant idea since QEII was first proposed. A long line of dollar bears – Bill Gross, Jim Rogers, Zero Hedge – have loudly and confidently proclaimed we'd see runaway inflation before long.
That was a U.S. dollar weakness trade – mainly based on inflation fears due to QEII.
Now oil prices have fallen dramatically over the last few weeks and QEII has all but ended. We don't have hyperinflation – far from it. We're staring deflation in the face.
The boom in commodities does two things for Australia:
- First, it makes the Australian economy hum. Australia supplies gold, coal and iron to China. This is a huge boost to the Australian economy.
- Second, higher commodities stoke inflation fears. Higher commodities mean higher cost inputs – which spill over into the broader economy. Not only that, but it's a large, obvious increase in the products people need to live.
Now the three major reasons traders flooded into the Australian dollar show signs of cracking:
- QE II has been a bust for inflation fears: QEII isn't even over and inflation never even saw 5%. Sorry USD bears, but 3% inflation isn't even close to hyperinflation.
- Commodities falling: Commodity prices are falling across the board. The potential reality of a China slowdown – or even meltdown – becomes more obvious every day.
- Australian economy wavering: Australian GDP actually fell 1.2% – nearly 5% annualized – in Q1 2011. The entire Australian economy is leveraged to the commodities boom. When floods knock out mining and commodities fall in price, the economy tumbles.
If the U.S. dollar makes gains – for any reason at all – these factors could turn on the Australian dollar with vengeance.
The smooth sailing faced by the Australian dollar is turning into a perfect storm. It's totally linked to the continued weakness of the U.S. dollar.
If this was the entire case against the Australian Dollar, it might not be enough to make me short the AUD/USD. But this is only part of the case. The carry trade is also leveraged to the inflation argument!
The carry trade is a leveraged long play on the AUD/USD. It cannot stand losses at all – and carry traders have zero long-term loyalty to the AUD/USD beyond piling up positive returns.
When the returns go away, the carry trade leveraged longs do too.
QEII ends in just a few days. With QEII inflation fears turning out to be totally baseless, the U.S. dollar has a renewed strength and vigor.
With the U.S. dollar likely to go on a bull run post QE II, the AUD/USD thus becomes a good short candidate.
Fundamental Support + High Interest Rates = Explosive Carry Trade
The fundamentals provided great protection for the AUD/USD carry trade. In a carry trade, traders pile into a currency – with leverage — because it has high interest rates relative to the funding currency.
The carry trade lit a fire under the AUD/USD, pushing it to record levels.
But carry trades are notoriously brittle. Carry trade money is the hottest of hot money. Because of the leverage involved, any losses are magnified. Carry trades are vulnerable to cascading losses once the rush for the exit begins.
Why the carry trade is so brittle – and dangerous to the AUD/USD
The carry trade is simple to understand. Buy a currency that has a high overnight yield and sell a currency that has low overnight yield (interest rates).
You get to collect interest on the currency you buy, while paying lesser interest on the currency you sell.
The overnight yield on the Australian dollar is 4.75%, compared to only 0.5% for borrowing in USD. Traders make an easy 4.25% — as long as the AUD/USD doesn't go down.
You make even more money when you do this trade with leverage. At 3X leverage, it's a cool 12% just from holding AUD vs. USD.
Now, given there were strong reasons for the AUD to go up in the first place –- QEII and the Commodities boom — you get fundamental "protection" on your carry trade.
You were protected from downside, in part because of other investors piling into the AUD/USD for other reasons.
And not just protection, but those same factors exponentially added to returns. If the AUD/USD goes up 10% over the year and you are holding AUD with 3X leverage, the return is closer to 45%. You get 12%+ (4.25% interest at 3X leverage), then add 30% (10% at 3X leverage).
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But a carry trade is the hottest of hot money. Carry traders – due to the leverage required to get decent returns – will not stand losses in the price of the currency.
Carry trades are brittle, because they seem to shatter at the end. Nobody wants to be the one left holding a bag of Australian dollars when nobody wants Australian dollars.
The price movement at the end of a carry trade can be huge. In May 2010, the AUD/USD carry trade unwound in just a few days – and lost nearly 14%.
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This is why the change in the fundamentals is such a big deal for the AUD/USD. The changes are big – but due to the carry trade, the impact of these changes on the price level of the AUD/USD could be huge.
Adding fuel to the fire, the change in fundamentals will lower the spread between Australian and U.S. interest rates.
The carry trade is dependent on the spread between the two countries' overnight rates. Any signs the spread between the two rates will get smaller are taken very seriously.
So lower commodity prices and lower inflation fears are very dangerous to the AUD/USD.
June or July could see Headline Deflation in the USA – and lower inflation in Australia too.
We're likely to see negative consumer inflation numbers here in the United States and it won't be much different in Australia. Falling oil and gasoline prices cut the heart out of the inflation argument – in particular from the commodities side.
Here is Jim Dolmas of the Dallas Fed:
Given gasoline's weight in the PCE — just under 4 percent of consumer expenditure — a 7 percent drop in price would shave just under 0.3 monthly percentage points off next month's headline rate. Barring another unusually strong set of price gains outside of gasoline, we expect June's headline rate not only to be below the core rate for a second consecutive month, but to come in slightly negative as well.
Negative headline June inflation in the USA! That's also known as deflation last I checked. (Hyperinflation in the USA – where are you???)
Deflation in the U.S. kicks the legs out from beneath the weaker U.S. dollar argument. But this is about the AUD/USD. Higher oil prices drove up inflation everywhere and falling oil prices could push down inflation across the globe – including Australia.
Inflation fears in Australia are evaporating faster than spilled water in the outback.
Sea Change for AUD/USD
The U.S. dollar weakness trade has turned out to be based on fears of high inflation that have not materialized. These same factors drove commodities higher. Higher commodities turbo-charged both the Australian economy and the interest rate spread for the carry trade.
But now, it's clear that fears of high U.S. inflation are hogwash. Commodity prices are falling.
Higher commodity prices had been a huge support for a higher AUD/USD – but these falling commodity prices are turning into reasons to exit the AUD/USD.
This is a huge sea change for the Australian Dollar. For the last two years, nearly every factor was in favor of higher AUD/USD price levels.
Now this has all changed, instead of supporting the AUD/USD, the forces are working against the AUD/USD.
And due to the hair-trigger carry trade, you won't have a chance to get out when things turn bad for the AUD/USD. The AUD/USD could lose 5%+ while we're asleep here in the U.S., then another 5% while you're deciding if you've missed the trade.
It might be time to get short the Australian dollar if you haven't already.
