By John Ross Crooks, Currency Analyst
www.worldcurrencywatch.com

Over the next six to eight months, our core trading strategy is based on three key ideas:

1.    Global demand will continue to deteriorate
2.    China will surprise on the downside
3.    Commodities prices will sink back to their 2001 levels

Based on these three views, my trading partner Jack Crooks and I are bearish on currencies that depend on commodities to support their growth. And within the pack of commodity players we are most bearish on the Australian dollar.

Right now, Australia is effectively a satellite country of China. In my opinion, the market is not even close to pricing in the plunging growth in either country just yet. But when the market does, I believe the Australian dollar will get pounded lower.

Now might be a great time to consider put options on the Aussie. Here’s a more detailed look at why…

The economy is in trouble and sinking fast. “The deterioration of the country’s terms of trade is crunching national income.

Recession now seems a formality: Growth last quarter, at 10 basis points, was the weakest in eight years. Households and farms are over-borrowed, and companies are even worse. Their financing requirement blew out to an all-time high last year of almost 8% of output.

With debt hard to come by, companies have three choices: Stop spending, raise equity or go broke,” according the Financial Times.

And the fact that Australia’s current account deficit is already the highest among the major currencies, estimated at 4.8% of 2008 gross domestic product (GDP), makes the currency vulnerable. (Note: the U.S. current account is estimated at 4.5% of GDP, but players have to hold U.S. dollars in order to transact trade and capital flow. They do NOT have to hold Australian dollars.)

China’s “Hard Landing” Will Clobber Australia: Not too long ago, China was everybody’s darling economy. But the crowd of China cheerleaders may be in for a very big surprise — a hard economic landing! Already Australia is suffering from the Chinese slowdown, but the probability that it will get much worse is rising fast as China’s growth numbers continue to fade.

“The one-time engine of global economic growth has been sputtering as a result of dented global demand for exports and over-zealous tightening policy at home. A hard landing, like recession, adds new fear to the mix. With shares and real estate worth sharply less, unemployment rising and deflation round the corner, companies and households are already reluctant spenders; household savings deposits rose by more than 20% in the year to November,” is how the Financial Times recently summed up the rising problems facing China.

As China goes, so goes the demand for commodities and the source of Australia’s growth. China’s troubles are the key reason I believe commodity prices will further to fall. And looking at a long-term chart of the Commodities Index, I think it will revisit 2001 territory — the year commodities prices blasted off.

Aussie yield support could fade fast. Australia has been a great place to park money during the past seven years. The country was growing along with commodities and the Reserve Bank of Australia kept their rates high to rein in inflation during this boom period.

The Aussie dollar has been the highest yielding of all the major currencies for many years, and still is. But the rapid deterioration in Aussie growth and the fact that governments are fighting deflation, not inflation, leads me to believe Australia’s central bank will hack much more off its official policy rate, which now stands at 4.25%.

I am not sure how far the RBA will cut rates, but I do believe the bank will aggressively cut rates. When they’re done cutting rates, the high yield differential that created such a seeming “no-brainer” demand for Aussie dollars will be gone.

When that happens, the Australian dollar should accelerate to the downside.

Bottom line: Australia’s growth should soon go into negative territory. The country’s already ugly current account deficit should grow worse. Australia’s key customer — China — will likely be buying a lot fewer commodities. At the same time, the Reserve Bank of Australia will likely cut interest rates much faster than now expected in an effort to generate growth.

All of this is bad news for the Aussie over the next several months.

Regards,
John Ross Crooks, Currency Analyst