Commodity currencies vulnerable to a sell-off

Commodity-linked currencies will be vulnerable to a sell-off as concerns about a slowdown in emerging Asia encourage investors to pare their exposure to risk and cut over-extended long positions before year-end.

The growth-linked Australian, Canadian and New Zealand dollars, which earlier this month began to fall from recent highs, are particularly sensitive to concerns China may slow as a result of policy measures aimed at curbing inflation.

Risk aversion is also negative for the three currencies, although the main trigger for their latest move downwards was a jump in Chinese inflation, which fueled speculation of further tightening, rather than the knock to sentiment from euro zone debt problems.

But barring a shock from China, yield-hungry investors may return in the new year to buy commodity currencies, including against the euro, because of the dollar bloc's robust economic fundamentals and higher interest rates.

The Australian dollar may struggle the most in the remainder of the year, having surged 16 percent over a 10-week period to hit a 28-year high of $1.0183 on November 5 before starting to drop back.

"It is noticeable with the Australian dollar over the last few weeks that rallies have been keenly sold into," said Michael Derks, currency strategist at FXPro. "This gives a sense that those who are already long are looking for good levels to sell."

Analysts say the Aussie has the potential to fall as low as $0.95 as investors book profits ahead of the year end, though it could rebound above parity in the new year.

The Aussie has been the most sought-after of the three this year as carry trades -- borrowing in low-yielding currencies to buy high-yielding assets -- made a comeback with U.S. interest rates near zero and the Federal Reserve opting for more easing.

Australian interest rates at 4.75 percent give a sizeable yield advantage for holding Aussie dollars over other major currencies. The market is pricing at least one 25 basis point rate rise over the next year.

But the Aussie is the most sensitive to monetary tightening in China, which could dampen growth and demand for commodities. Australia's close trading links with China mean investors often see the Aussie as a proxy for Chinese and Asian growth.

"Tightening in China is the critical story for commodity currencies," said Simon Derrick, currency strategist at Bank of New York Mellon. "China is infinitely more worried about inflation than about slowing growth."

China raised banks' reserve requirements on November 19 for the second time in as many weeks. It hiked interest rates on October 19, with more expected.

The Canadian dollar may fare less badly, however.

Analysts at Deutsche Bank see downside risks to the Aussie against the Canadian dollar, on the grounds it would be best placed to benefit from an upturn in the U.S. economy.

"We now see the prospects of a correction lower in Aussie/Canadian dollar as stronger than the prospects of further gains."

The Canadian dollar is less vulnerable than the Aussie and kiwi in risk averse markets, and it rose much less versus the U.S. dollar between August and early November.

Some analysts are less enthusiastic about the CAD, saying the Bank of Canada may be slow to raise interest rates, which are at only 1 percent, although strong inflation data this week may mean rate rise sooner than expected.

"CAD will not burst through parity (against the U.S. dollar) until we get the BOC raising rates," said Kit Juckes, currency strategist at Societe Generale.

POSITIONING

Investors have cut long positions in commodity currencies, especially the Aussie, in recent weeks but analysts see more adjustment to come.

"There's quite a lot of heavy positioning that's to be unwound and we could see a slight acceleration of that, and Aussie and kiwi are likely to feel that more than the Canadian dollar," said Christian Lawrence, currency strategist at RBC.

One-month Aussie risk reversals have shown an increased bias to buy Aussie put options over calls in recent weeks, indicating concerns the spot price will fall further.

Nicole Elliott, technical analyst at Mizuho, said the Aussie could fall to its late October low at $0.9650. Below that level, it risked targeting $0.9380 -- the 38.2 percent retracement of its May to November rally -- especially with liquidity thin.

"In 2008, the hardest hit was the Aussie, precisely because it had been the darling and the carry trade one, and it still has that problem," she said.

Elliott still believes the currency should strengthen in the medium term, however -- a view shared by most analysts.

"The Aussie is still one of the few currencies people are happy to hold," said Niels Christensen, strategist at Nordea in Copenhagen.

source