The Aussie is getting hammered this morning on news producer prices unexpectedly fell 0.4% last quarter; consensus estimates were a 0.6% gain.

AUDUSD Daily:

It may be too early to forecast deflation is settling over the Australian economy. Analysts cite the relative decline in Aussie from its perch near US dollar parity back in July of last year, and suspect this may keep import costs inflated. But once again, we continue to believe it all comes back to China.

China demand drives commodities demand for Aussie stuff. And though we are surprised by how well China is holding, given our misgivings about the veracity of economic numbers conjured up by the politburo, we remain wide open to a major disappointment. Australia now being the veritable canary in the coal mind for Chinese demand, we watch with interest. For if China is fine, any decent Aussie move lower might be a gift (key word there is might).

The optimistic story for China we thought was summed up very well by Morgan Stanley recently (a very plausible one indeed):

“[U]nder this ideal recovery scenario, we envisage the Chinese authorities taking a rather unorthodox approach in managing the economic downturn: boosting the real economy through reflating the stock market first. The goldilocks recovery scenario would therefore feature a series of positive catalysts, such: 1) a technical rebound in growth as destocking runs its course and trade finance normalizes somewhat in 1Q09; 2) on the back of a policy-induced, liquidity-driven stock market rally (despite weakening fundamentals), the confidence of consumers and private investors is boosted despite job loss and slower sales/income growth, thus preventing too rapid a slowdown in consumption and private investment in late 1Q and 2Q09; 3) the effect of fiscal stimulus starts to show in a major pick-up in public investment growth in late 2Q or early 3Q09; and 4) the G3 economies bottom and stage a tepid recovery in 4Q09, improving external demand and further boosting confidence.”

“Although we had attached a low probability to this ‘everything-goes-exactly-right’ scenario at the time, it is looking increasingly probable that this scenario is playing out. In particular, it has become evident that the Chinese authorities, who still have a powerful and pervasive influence over the business community (including in particular the banking sector), are determined to leverage the ‘strong balance sheet’ of the economy for a ‘decent-looking income statement’ of the economy in the next couple of years.”

China Index Daily:

So far so good on the Chinese stock market reflation front.

Stay tuned.