Aussie looking vulnerable as investors fear Chinese bubble

SINCE equity markets began to rally in March, traders have been riding the wave of the strong Australian dollar. Since then, going long on the currency has been a no-brainer for foreign exchange traders across the world. Those who entered positions back then will have benefited from the 39 per cent rise in Australian dollar against the yen and the 33 per cent rise against the US dollar.<br /><br />But as of yesterday, when the Reserve Bank of Australia (RBA) kept interest rates on hold, the good times for the Aussie dollar are over. Traders long on Aussie pairs should not expect to keep making such easy gains. The factors that drove the strengthening are running out of steam and are outweighed by concerns over China and the sustainability of the recovery.<br /><br />There were three factors behind the almost one-way movement in the Aussie dollar. Firstly, it is a risk-positive currency and therefore benefited from the rally in equity and commodity markets as investors regained their appetite for risk in light of an improving global economy.<br /><br />Secondly, although interest rates have fallen from their peak of 7.25 per cent last August to 3 per cent today, this remains substantially above the near-zero rates of many other advanced economies. This yield differential was pounced on by carry traders looking to profit from the higher rates available in Australia.<br /><br />Thirdly, the fundamentals of the Australian economy have been positive. Although its economy contracted in the first quarter, it rebounded in the second to be one of the only major economies to avoid a technical recession. This fuelled expectations among currency traders that the RBA would be one of the first, if not the first central bank in the developed world, to raise interest rates. <br /><br /><strong>HIKING RATES</strong><br />&ldquo;Excessive Australian dollar long positions have been built on the expectation of the RBA hiking interest rates early and the economy receiving a further boost via improving terms of trade,&rdquo; BNP Paribas currency strategists wrote in a note yesterday.<br /><br />These excessive long trades will have been disappointed not only by the RBA keeping interest rates on hold yesterday but also by the decidedly dovish tone of the accompanying statement from the RBA governor Glenn Stevens.<br /><br />Stevens said: &ldquo;The effects of economic weakness on the balance sheets of financial institutions will still be coming through for a while. This constitutes one of the main remaining risks to the global expansion. For the recovery to be durable, continued progress in restoring balance sheets is essential.&rdquo;<br /><br />He added: &ldquo;The Board&rsquo;s judgement is that the present accommodative setting of monetary policy remains appropriate for the time being. The Board will continue to adjust monetary policy so as to foster sustainable growth in economic activity and inflation consistent with the target.&rdquo;<br /><br />As a result, analysts have quickly become negative about the Aussie. At BNP Paribas, the strategists believe that the Australian dollar is looking &ldquo;vulnerable not only against the US dollar, but across the board.&rdquo; Some analysts say that in the short to medium-term the currency is beginning to look fairly toppy, although they do agree that in the longer-term the good fundamentals of the Australian economy should continue to support the Australian dollar.<br /><br />The currency may also come under pressure from the impact of China on its terms of trade. In the second quarter, Australia&rsquo;s current account deficit has blown out to AU$13.4bn due to weak exports and outperforming imports. If China fails to deliver the kind of growth that it and the markets are expecting, then this will weigh heavily on Australia, which exports a lot of its raw materials there.<br /><br />BNP Paribas says: &ldquo;Slowing Chinese credit growth is likely to continue to put pressure on commodity prices, and with effects of stimulus measures likely to begin to wear off over the next few months we believe the risk is still that the RBA delays hikes for longer than the market expects.&rdquo;<br /><br /><strong>BADLY STUNG</strong><br />British investors in Australia will have been stung particularly badly by the rise in the Australian dollar, which hit a high of $1.92 against the pound during trading yesterday. Christina Weisz, sales director at Currency Solutions, suggests that both investors and traders make the most of corrective pullbacks in the Australian dollar-sterling rate to jump into the currency pair.<br /><br />So what level should we expect the Aussie to fall to?BNPParibas&rsquo; strategists predict that Aussie dollar-US dollar is a sell against the 0.8540/60 resistance level, that Euro-Aussie is expected to bounce from 1.6910 and Aussie-New Zealand dollar should fall below 1.2430.<br /><br />Jamie Saettele, senior currency strategist at FXCM, says that if there is a drop below $0.8151, then this would negate any bullish potential and open up a move to $0.7700. &ldquo;The risk of a sharp decline is high,&rdquo; he warns. Forex traders could therefore look to go short on the Aussie dollar-US dollar pair in the short-term, selling on the rallies towards the $0.8478 high.<br /><br />While the long-term outlook may be positive for the Aussie dollar, the reluctance of the RBA to raise rates and the continued concerns about a Chinese bubble will weigh on the currency over the next few months. For now, it&rsquo;s time to park those surf-boards in the garage.<br />