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Aussie in for Rough Times

Richard Cox

NEW YORK ( TheStreet) -- The massive rally in the Australian dollar since the end of 2008 has taken a major turn in recent weeks, and a confluence of fundamental factors (both internal and external) suggest that this bearish run will continue.

Price moves in currencies tend to slow during the summer, but this year has been different, as implied volatility in the AUD/USD has hit highs of 15.5%. In early May, I warned of this potential weakness, so at this stage it is important to revisit the bearish case for the currency to see if these declines can continue.

Three separate factors are currently seen moving markets: Unstable credit conditions in China, a possible near-term tapering in quantitative easing stimulus from the US, and the broad expectation that the Reserve Bank of Australia will continue with further interest rate reductions before the end of this year.

So while some sections in the market might be looking at recent Aussie weakness as a new opportunity to buy the currency, there is not much in the fundamental picture to suggest a bullish reversal will be seen any time soon.

At the central bank level, markets are pricing in another 40 basis points in interest rate reductions from the RBA. This would take the country's official cash rate to a new all-time low (from its current levels at 2.75%) and take away some of the relative yield advantage that accompanies long positions in the Australian dollar.

If these expectations turn out to be accurate, the Aussie will lose its position as the highest-yielding currency amongst the majors (overtaken by the currency's counterpart in New Zealand).

At the same time, we are seeing markets reposition themselves for changes in policy by the Federal Reserve. Reduced monetary injections from the Fed could now come as early as September, and this brings with it a supportive climate for the U.S. dollar.

This also suggests that yearly lows in currency pairs like the AUD/USD haven't yet arrived. So, while the recent declines in the Aussie have been drastic, there aren't many reasons to believe we'll see significant bounces from current levels.

The other global issue to consider is China, where renewed concerns over the country's troubled credit system have injected additional volatility into trading markets.

China is Australia's largest trading partner, as a central location for metals and other raw materials exports. Stock markets in China have seen single-session declines of more than 6% this week, so it is clear that these underlying worries are deep-rooted.

Efforts by the Chinese leadership to limit shadow banking practices are at the root of the issue. Shadow banking involves unregulated lending by Chinese banks in China to companies with limited lines of credit.

Proposed measures to reduce these questionable (and potentially destabilizing) practices will raise borrowing costs for Chinese companies, cut into manufacturing prospects and reduce demand for raw materials exports in Australia.

This combination is why the case for the Australian dollar remains bearish.

Recent weakness in the currency has been extreme, and corrective moves upward cannot be ruled out. But any bullish changes are expected to be met by renewed selling pressure -- and should be viewed as new opportunities for short positions.

Restrictive credit conditions in China, the underlying dovish bias at the RBA and potential reductions in quantitative easing stimulus at the Fed create a perfect storm for Aussie bears and establish the conditions that should prevent the currency from gaining traction in the Northern Hemisphere's summer.

At the time of publication, the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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