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The euro's long run average against the Australian dollar has been A$1.7, whereas currently it trades at ~A$1.25. Goldman views its "long euro and short AUD strategy"to be the trade of the century. The rationale for the strategy goes like this: Europe's problems have already been priced in the currency, whereas the problems for the Australian currency are manifesting themselves through the interest rate cuts, a tighter fiscal policy, and the menace of a slowing China affecting the Australian economy.

Chart 1: EUR: AUD


(Click to enlarge)

Goldman also holds the view that the Australian dollar is at least 20% overvalued against the U.S. dollar, and given the slowing economy and the pressure on commodity prices, a sharp correction is in order. Australian exports stood at A$25,757 million in July 2012, with the agriculture and mining sector accounting for 52% of total exports. The country is resource rich and exports agriculture products and minerals, such as wheat, wool, iron ore, gold, and also liquefied gas and coal. Its largest exports market includes Japan, China, European Union, South Korea and the U.S.

Goldman predicts that over the medium term, we will experience a gradual decline, but a substantial fall in commodity prices could result in a correction as low as U.S.$0.65.

In our earlier article on the mining boom in Australia, we highlighted how its mining sector had helped keep the economy afloat amidst a global slowdown. China's demand for resources to build its large infrastructure had helped the mining sector in Australia receive a healthy boost. With that being said, we believe the decline in commodity prices, rising operating costs, a slowdown in China, and hiking debt levels will not allow the country's mining sector to maintain its past boom.

Possible risks to Goldman's strategy relates to the extent of a slowdown in China, and the economic recovery in Europe. To believe that Europe is on track to a recovery will be too optimistic. Although steps have been taken in the right direction, more needs to be done; as the IMF puts it, "Courageous and cooperative actions are expected from the nations to bring about a change in Europe's woes."

For the euro currency to appreciate, things will have to start getting better practically, and not just rhetorically. For example, the euro declined 25bps following the news that S&P cut Spain's sovereign rating to BBB-, just above the junk rating. S&P holds the view that the central government lacks the capacity to deal with the ongoing financial distress.

As far as China is concerned, although the economy is slowing down, there seems to still be a debate on whether the economy will experience a soft or hard landing. We had previously, in our article, briefly described some of the short comings of the Chinese economy, such as a weak domestic demand. China is in fact Australia's largest trading partner, and its performance will impact the path of Australia's economic growth. The sensitivity of the economy's dependence on China will in turn determine the movement of the Australian dollar.

To play the possible rebound in the euro and a depreciating Australian dollar, investors could consider (short sell) the ETF Long AUD short EUR ETN (XBJJ). The fund has had a YTD return of 1.83%. Currency Shares Australian dollar Trust (NYSEARCA:FXA) is another ETF whose objective is to reflect the price of the Australian dollar in terms of the USD.

Biggest Risk:

The biggest risk to the thesis is a collapse in euro as a result of:

1) PIIGS problem is not resolved: In this case a long position in EUR is not justified as the slow growth in Eastern and Central European economies will put a cap on euro's appreciation against AUD or any other currency.

2) Euro-Breakup: The probability of such an event is remote. However, this "black swan" event will result in Long EUR/AUD trade to result in big losses. No one knows where will euro trade in case of a breakup, however we all know euro decline will be enough to wipe out returns of any portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Macro Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.

Source: Goldman Sachs' 'Trade Of The Century': Long Euro Vs. Australian Dollar