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With the Aussie at record highs against the Euro and the Pound, is there an argument for taking out longer-term FX contacts to short the Aussie?


The Australian Dollar’s steady advance against the Euro and the British Pound over the past 17 months has led to increased speculated that the currency’s value is overdone and a correction imminent. Indeed, using purchasing power parity (PPP) as a crude approach to determine “fair” exchange rates, both European currencies are now undervalued against the Aussie, the Euro by 11.25% and the Sterling by a hefty 29.15%. The long-term rationale for AUD strength seems reasonable, with higher interest rates and the prospects of significantly greater further tightening over the next 12 months making the currency understandably attractive from a yield-seeking perspective. That said, there are compelling arguments to suspect that a corrective pullback is indeed ahead.

The near-term outlook for the British Pound against the spectrum of major currencies including the Aussie is closely linked to the outcome of the UK general election set to take place on May 6. The markets are closely monitoring the contest, with a victory by the deficit-hawk Conservatives (now in the opposition) seen as preferable to the currently ruling Labour who promise to defer unwinding expansionary policy until the economy is on firmer footing. Indeed, prices have become acutely sensitive, jumping with the release of every opinion poll as the prospect of anything less than a decisive Conservative victory is apparently being seen as broadly negative for the UK’s fiscal health and its sovereign credit outlook. Intense GBPAUD selling has paused for the time being with prices consolidating in a 400-point range above the 1.63 figure since early March and a Conservative triumph certainly seems like it would be a potent-enough catalyst to spark a meaningful upswing.

Turning to the Euro, PPP-based valuation readings suggest the urgency of a correction is far less pronounced it is with Sterling as prices stand well below the 20% overvaluation extreme threshold. Continued fiscal stress on the Euro Zone’s southern periphery – first in Greece and now increasingly feared elsewhere – promises to keep firm downward pressure on the single currency in the near term. Indeed, investors can hardly be blamed for wondering what the sloppy approach to the EU’s dealings with a small member state like Greece – just 2.6% of the currency bloc’s economy – could mean in the event of a flare-up in a larger country like Spain (11.8% of EZ GDP) or even Italy (17% of EZ GDP).

Still, an Australian-borne catalyst may help engineer a broad correction in AUD that spills over into EURAUD as the high-yielder pulls back across its major pairings. As mentioned above, the Aussie has relied on an unabashedly hawkish central bank to engineer its most recent gains. RBA chief Glenn Stevens has been candid in outlining his reasons for pushing rates closer to “average” levels (presumably 5-6% given where the benchmark borrowing costs has been over the past two decades), arguing that the buoyant resource  sector will propel output growth despite the governments’ unwinding of stimulus measures. However, this scenario is not without a major downside risk: a slowdown in China.

The administration in Beijing has been trying to rein in growth amid warnings about asset bubbles and runaway inflation, clamping down on lending by raising reserve requirements and allowing bond yields to creep higher. Robust Chinese demand is the central engine driving Australia’s mining boom and a slowdown there is likely to act as a major drag on the sector’s performance. The situation is made all the more dangerous by a simmering trade dispute between China and Australian mining firms over prices on future contracts, with tensions likely to intensify after Beijing convicted Rio Tinto employee Stern Hu on corruption charges and announced a moratorium on iron ore purchases from leading Australian producers (Rio and BHP Billiton) for at least two months, allegedly to resolve a supply glut. On balance, these stgelopments threaten to rob Australia the very thing that has kept it relatively insulated from economic turmoil even as the world suffered the worst recession since the Second World War over the past two years, an outcome that promises to put rate hikes on hold and sink the Aussie.

Ilya Spivak, Currency Analyst, at DailyFX.com

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