Australian Dollar Due To Sell Off

Earlier in the week, while doing an analysis of the recent COT report, I noticed something peculiar in the data for the Australian Dollar. During the past six weeks the number of futures contracts held by long speculators had ballooned from slightly less than 10K contracts to almost 100K contracts.

Now, the fact that specs aggressively bought is not unusual. The peculiar relationship is the minimal impact all this buying had on the market. (AUDUSD, UUP, FXA) Markets generally go in the direction of the money flow. Concentrated buying moves markets higher and selling sends the market lower. This market did go higher, but not by much, and it has since reversed. Under the 1.04 handle, there may be more spec longs with a loss than there are with profits. What if the specs have chosen the wrong side of the market, and instead we are headed lower?

Let us reconstruct how we got here. Even those with only a cursory awareness of the Chinese stimulus and consequent building boom, know that Australian commodities provided the raw materials for the Chinese recovery.

The biggest export to China was iron ore. The value of the ore was 20/25% of total Australian exports during the last three years. When the Chinese applied the brakes to their economy, attempting to negotiate the fabled economic soft landing, the usage of steel and the demand for iron ore slowed.

Iron ore has been supplied to China by Australian miners BHP Billiton (NYSE:BHP), Rio Tinto, (NYSE:RIO) and the Brazilian miner Vale (VAL S. A.). To overcome the additional 30 days of steaming time from Brazil, Vale introduced what they named Valemax vessels. These massive bulk ore carriers, over 200,000 tons, hastened the flow of ore to China just as the economy started to contract. Now, iron ore is at a 2 1/2 year low and recovery is a distant mirage.

For Australia, the boom in commodity demand has been a mixed blessing. This is a classic case of what Investopedia calls "Dutch Disease, Negative consequences arising from large increases in a country's income. Dutch disease is primarily associated with a natural resource discovery, but it can result from any large increase in foreign currency......"

For the Australian Dollar, the rally was dynamic. It moved from a low close to .60 during the middle of the financial crises, to above 1.10. As the commodity boom expanded, creating Australian wealth, the Reserve Bank of Australia decided, in the name of controlling inflation, they would raise rates.

This of course sent the Aussie higher. At that time, most global economies were struggling, and money rates were low. Investors, unable to find yield elsewhere, moved their investments to Australia. As the money flowed into Australia, the Aussie moved higher.

At the end of 2011, the Australian Office of Financial Management estimated that 80% of the outstanding government debt, over A$200B, was owned by non-Australians. Global market conditions will influence whether foreign investors will continue to hold the debt, or will they become frightened and move the money elsewhere. Naturally a concentrated movement from Australia would hurt the currency.

The remnants of the commodity boom may have contributed to bad policies and possibly some expensive habits. During the good times it is easy to be complacent, and forget that economic cycles do not last forever. Last year Australia, by a slender margin, passed a comprehensive carbon tax bill. The Greens may feel good about this bill but for those producing or consuming energy, the bill is a labyrinth of government policies.

The carbon tax in Australia is complicated, a tax on energy producers and consumers. The government envisioned a high price for carbon, thereby providing ample revenues for various welfare projects. With carbon prices much lower than forecast, there is a possibility that the grand spending plans may lead toward a budgetary deficit.

If the mining boom slows, as many expect, there will need to be a revival of manufacturing activity which may prove difficult. Higher labor cost, a strong currency, and the additional energy costs because of the carbon tax will all hinder manufacturing activity. With a population of slightly less than 23M, the domestic market is small. Export markets are needed but will be hard to open because of the elevated production costs and the elevated value of the Aussie Dollar.

The Australians are also big spenders. Despite the commodity boom, when prices were high and exports were soaring, Australia still had a current account deficit. In the first quarter of 2012, after the demand had started to slow, the Australian current deficit was AUD14,892M. Since 2008, when the Chinese stimulus plan began, exports were large, but Australia still had a current account deficit in every quarter.

In a macro sense, foreign investments into Australia have financed the current account deficits. Will this continue should Chinese demand languish and the Aussies run a higher trade deficit?

We note, then, that the speculators are loaded up long the A$, and have yet to be rewarded for the position. Longer-term, we see some fundamental reason the currency can work lower. Events elsewhere in the world may influence risk appetite and consequent A$ demand. Next week will be interesting with the RBA meeting on the 4th, the ECB Press Conference on the 6th, and the US payroll reports on the 7th. We are inclined to use any modest strength to sell the A$.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.