Australian Dollar's Run May Hit a Short-Term Snag

$3.2 billion. That’s the record trade surplus Australia’s Bureau of Statistics announced on August 3, thanks in part to Chinese demand for the country’s rich iron ore and coal exports. And that’s just the latest good news from the island continent that has speculators feeling bullish about the Australian dollar (AUD).

But a closer look at the underlying fundamentals, including central banking mentality, reveals ample evidence that the currency may be in for a brief and wayward turn lower.

Don’t get me wrong – there are a lot of good things happening in Australia. Its annualized GDP is expected to grow at a 3.5-4% pace in 2010, led by strong manufacturing sector activity. And the Australian Industry Group and PriceWaterhouseCoopers recently released a joint survey that showed continued improvement in the sector. Its index rose by 1.5 points to 54.4 in July, up from 52.9 in June. (Anything above 50 indicates expansion.) The report’s sub group assessments were also optimistic, with both production activity and order flow jumping higher as a result of increased business spending and demand.

The rise in production and manufacturing activity has been a boon for the labor market. Australians are finding employment in every corner of the country, which is driving the national unemployment rate down. As of the latest release, unemployment in the “land down under” was a paltry 5.1%. Comparatively, US unemployment currently stands at double the rate.

So, growth and employment prospects have added to bullish Australian dollar sentiment. Higher rates of economic expansion are expected to fuel consumption and more interest rate hikes by the nation’s central bank.

But not everything is as rosy as it seems. Yes, people are making money. However, with the fears of a global recession and higher interest rates at home, Australians aren’t spending as much as they should. This is showing up in the bottom-line sales numbers for many of Australia’s retailers. Retail consumption has been appalling in the last couple of months, rising only minimally since the beginning of the year.

Even more disappointing is the fact that Aussie consumption has now dipped below the levels in the United States – where spending is about 2% and the savings rate has now crossed the 6% line. Granted, retail sales don’t contribute a whole lot to the gross domestic product of the region – constituting about 23% of overall productivity. But it’s never good when consumers aren’t willing to spend in good economic times.

Lower spending and consumption breeds lower prices as retailers discount merchandise to compensate for the drop in sales volume. The competition for consumer market share will bring prices down across the board – fostering lower inflationary pressures. And that puts Australia’s central bank into standby.

Governor Alan Bollard and members of the Reserve Bank of Australia rely on an inflationary target of 2-3%. The Bank began raising rates last year when it looked like the inflation rate would breach 3%.

But consumer prices are now expected to trail off from their recent 2.7% reading – well below the 3% target. So the central bankers will contend that inflationary pressures remain contained, and the economy is growing at a moderate and controlled pace. The pause in rate hikes will leave some high-rate seekers in the Australian money markets disappointed, sparking a short-term exodus as investors prefer to take profits while they can.

So while the Australian dollar is approaching four-month highs, the short-term sentiment is bearish.

Australian assets are overbought. Stifled consumer spending threatens further Aussie economic expansion. And expectations are for no further moves in monetary policy until next year.

Taken together, it leaves little impetus for another leg higher in the Australian dollar in the meantime.

Richard Lee
for The Daily Reckoning