AUSSIE TOP MIGHT BE NEAR

AS THE old adage goes, in the land of the blind the one eyed man is king. In the currency market the Aussie has become the one eyed man. Starved for yield, FX investors continue to flock to the Australian dollar, despite growing evidence that growth down under is decelerating quickly.

Last week Australian employment surprised the market, by printing at - 29,300, versus a forecast of 10,200, while the unemployment rate decreased to 5.2 per cent from 5.3 per cent expected as the participation rate declined to 65.2 per cent. The internals of the labour report were not nearly as gloomy as the headline number would suggest, with the vast loss in jobs coming from the part-time sector. Overall however, Australian employment growth has been nearly flat in 2011 – its worst performance since 1992.

As a result of last week’s data, interest rate markets have now priced in an 88 per cent probability that the Reserve bank of Australia (RBA) will lower rates once again at its next meeting in February. This week the market will be watching the Australian inflation numbers very carefully. Yesterday’s Producer Price Index (PPI) data has already printed softer than expected at 0.3 per cent, versus 0.4 per cent eyed, but the true focus of the market will be on the Australian Consumer Price Index (CPI) report scheduled for 12.30 am tomorrow morning. The market anticipates a sharp decline to 0.2 per cent, from 0.6 per cent the month prior, but if the data prints negative, like it did in neighbouring New Zealand last week, the odds of a rate cut will rise to nearly 100 per cent.

Meanwhile, boosted by its G-20 leading yield of 4.25 per cent, the Aussie continues to soar, as investors ignore the economic warning signs. On Monday, Aussie dollar-dollar climbed above the $1.0500 for the first time since November. Is this the start of a new run towards the all time highs at 1.10? I doubt it. Ultimately, a bet on Australia is a bet on China and China is clearly slowing down. The latest Manufacturing Purchasing Managers Index (PMI) report from China showed that business activity showed no improvement registering a reading 48.8 – its second consecutive month of contraction.

Despite rising exports to China, Australia runs a current account deficit of more than 2 per cent of GDP and a budget deficit of around 3 per cent. The current account deficit has been easy to balance because of tremendous investment flows into the Aussie dollar, but if those flows turn into a trickle, as the rate continue to decline, the Aussie will have to depreciate. Some analysts are calling for as much as a 100 basis point cut in the benchmark rate this year. If that were to occur, the Aussie could tumble to as low as $0.9000 as carry traders exit their positions.

Technically, if the Aussie clears the $1.0500 handle it can run all the way to $1.0700 level before encountering the double top from September and October of last year. Yet longs should be cautious at this point. The upside in the pair is relatively limited, while the downside could be considerable if the RBA were to compress yields further.

One interesting way to play Aussie weakness may be through a short on Australian dollar-Canadian dollar cross. As growth in Asia begins to slow, while activity in North America picks up, the pair could head towards parity from its current level of Ca$1.0600.