Bullish Aussie dollar will be threatened by Chinese bubble

THREE weeks ago, risk aversion was firmly back in the markets and commodity currencies were looking shaky. But equities and commodities have been surging across the board as investors rediscover their taste for risk. <br /><br />In such an environment, the Australian dollar ought to be doing well thanks to its economy&rsquo;s dependence on exports of base and precious metals, supported by the expectation of an upturn in the global economy and sustained Chinese growth. And Australia is looking strong: of all the major economies it has escaped the most lightly from the global financial crisis, avoiding recession altogether. <br /><br />But despite all this, no one in the markets was quite expecting the Australian dollar to hit its highest level against the greenback in almost eleven months during Asian trading hours yesterday before extending its gains in the London session. The Aussie dollar almost hit 0.8340 against the US dollar and a session high of 79.29 against the Japanese yen. <br /><br />The reason for the sharp jump in the Aussie dollar was comments by Glenn Stevens, the governor of the Reserve Bank of Australia (RBA). Stevens said that he could imagine more upside risks to the&nbsp; economy to balance out the downside risks, and that it appears the domestic downturn may not prove to be a serious one.<br /><br />Crucially though, Stevens suggested that central banks will have to consider removing &ldquo;exceptional accommodation in due course&rdquo; and couls therefore hike rates, which are already at 3 per cent.<br /><br /><strong>WIDENING DIFFERENTIALS</strong><br />BNP Paribas currency strategists say: &ldquo;If upcoming data continues to surprise on the upside then the market will speculate that the RBA would be one of the first to withdraw accommodation. Widening interest rate differentials would suggest further Australian dollar support.&rdquo; <br /><br />However, before you think about going long on the Aussie dollar, remember that the currency&rsquo;s outlook will depend crucially on China because of the extent to which Australia exports base materials to China to feed its production demand. The Australian Department of Foreign Affairs and Trade says that trade to China was 15.1 per cent of the country&rsquo;s total in 2008. Iron ore and concentrates exports made up more than half of the total exported in terms of value last year.<br /><br />Chinese growth has remained strong despite a collapse in demand in its main export markets. But China&rsquo;s domestic market is not yet strong enough to maintain growth in the face of plunging global demand. Not only is output growing rapidly, so too is bank lending and it is not clear whether it is reaching the real economy or simply leading to an asset market bubble. <br /><br />The 10 key industries in China only received 30 per cent of total lending by the Bank of China in the first half of 2009. Any announcement by the Chinese on a tightening of policy would lead to substantial position adjustment and investors looking to go long on the Aussie dollar should be aware of this. <br /><br /><strong>OVERWHELMING DEPENDENCE</strong><br />But the expectation from the RBA&rsquo;s side is clearly that China will continue to offer the Australian economy some support, says John Hardy, FX strategist at Saxo Bank. &ldquo;We think it is more than difficult to believe that China can make a seamless transition from the days of global imbalances and overwhelming dependence on a production-based, export-driven economy.&rdquo; If China is over-extended then this will prove negative for the Australian dollar and what looked like a breakout in the Aussie dollar-US dollar could be little more than a fakeout. <br /><br />Hardy adds: &ldquo;The strength in the Australian dollar is also at odds with signs of nervousness in equities and a resurgent yen yesterday. If equities sell off and bonds rally this week, then the Aussie&rsquo;s break higher will not hold here.&rdquo;<br /><br />It would be well worth currency traders already long on Aussie dollar holding in the trade, and they should remain long from 0.822 with a stop at 0.824 and target 0.84. But for those not already in the trade, it might be better to wait for any retracement lower.