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The coming Australian dollar collapse

However, all good things come to an end. In the current market, the trend is your friend until the trend comes to an end. So let us call a spade a spade, mates, Aussie style.

I believe the Australian dollar is going to collapse to 64-66 cents in the next six months and therefore recommend Aussie shorts in the spot FX market, sale of Aussie futures and long put option contracts on the Chicago IMM. If I am right (and I may well be wrong - FX is the mother of all treacherous leveraged financial casinos!); investors in the UAE who agree with my Aussie dollar view can well earn 200 to 400 per cent on strategic option trades.

My bearish stance on the Aussie dollar emanates from an existential reality in the international financial markets; high yield commodity currencies move on speculative capital flows, the proverbial not money that makes the best laid plans of mice, men and central bankers oft go astray, hot economic fundamentals. After all, the Aussie soared 50 per cent against the buck even though Australia's trade deficit is a shocking 6.5 per cent of GDP, the worst in the Western world. Yet the Aussie was the unquestioned beneficiary of the carry trade in the foreign exchange market and China's insatiable demand for commodities in 2003-2004. As the Federal Reserve slashed interest rates to 40 year lows after the collapse of the tech bubble and 9/11 in 2001, hedge fund and Wall Street prop desk dealers borrowed money at zero real rates in New York, invested it in the Australian bond market, which offered the highest AAA sovereign yields on earth. The result? Exceptional demand for the Australian dollar, not exactly the most liquid currency in the Euromarkets where even a slight imbalance in the supply-demand equation creates a wide swing in the price of Aussie money.

FX dealers in Gulf banks often ask me about my insights and uncanny track record in predicting major currency moves. My answer? As a bond trader, I constantly track international interest rate differentials, the guts of the FX market. When I recommended the Aussie in my KT columns, the spreads between US Treasury and Aussie government bonds was no less than two per cent. It is a mere 120 basis points now that the ten year Uncle Sam note is 4.15. PIMCO the world's most powerful fixed income fund manager, has a global strategist who is a good friend in its Newport Beach office. My friend at PIMCO believes the US Treasury - Aussie bond spread will tighten to 70 basis points in 2005. If the spread narrows, as I agree it will, it will trigger sales of the Aussie dollar by the offshore fund managers who arbitrage untold billions in the global debt bazaar. Interest rate spreads will prove the kiss of death for the Aussie dollar in 2005.

The second reason I am now short Aussie dollar is my belief that the Reserve Bank of Australia knows an overvalued currency can tip the economy into recession. Note that the Australian central bank has not raised interest rates for a year, the economy has slowed down to its lowest rate since John Howard came to power in Canberra, Treasurer Peter Costello has twice slashed his GDP growth forecasts to per cent. A strong Aussie dollar hurts its manufacturing exports and the risk of recession is now tangible since retail sales have fallen since October. The central bank has no problem with a lower Aussie dollar, the 20 year average exchange rate was 70 cents. As global hedge funds price recession risk in Australia, the Aussie dollar carry trade will unwind with a vengeance.

The December 14 FOMC minutes have made it clear that the Federal Reserve Board's definition of monetary neutrality has now shifted to a restrictive target. So, as the Eurodollar futures contract in Chicago predicts, the Fed will continue to raise interest rates in the next three FOMC conclaves. A 3 per cent Fed Funds rate is a disaster for the Aussie dollar and the commodities markets where real dollar interest rates just kill bull runs. No less than sixty percent of Australian dollar exports are iron ore, copper, coal and gold.

If China credit tightening and a rise in real U.S interest rates hit commodities, the Australian dollar will be the loser of the first resort. Ironically even as the stars are now in alignment for a major Aussie dollar sell off, the lambs in the Chicago futures pits are blissfully aware of their own doom once the slaughter begins. There are 27000 odd net long Aussie futures contracts on the Chicago IMM, four times the historic average. This is suicide for Aussie dollar bulls because it proves the hot money is still long up the wazoo Down Under. What happens when the FX kings turn sour on the Aussie dollar in 2005? Take a guess.