The outlook for the Australian dollar is dim, according to research from Westpac Institutional Bank, a major Australian bank.
In the past few weeks, the Australia dollar has surged in the global risk-on environment that was largely fostered by easing fears about the Europe debt crisis. Against the U.S. dollar, it jumped 14 percent from Oct. 4 to Oct. 27.
This rally, however, may not be sustainable. Below are 3 reasons listed by Westpac.
1. The rally lacks long-term investors
A sustained move in the forex market usually requires long-term investors, namely real money (long-term managers who use no leverage) and sovereign institutions (e.g. the Chinese central bank).
In July to September, long-term buyers dumped risk assets like the Australian dollar on a broad risk-off liquidation. In the risk-on rally in October, they have bought back some Australian dollar.
However, as shown in the chart below, the long-term buying significantly lags the rally in the Australian dollar.
This means short-term speculators are largely behind the move, which makes it not very sustainable.
2. The Australian dollar is overvalued
The Australian dollar is overvalued, according to Westpac's financial model that tracks the historical relationship between the Australian dollar and interest spreads, commodity prices, and risk appetite.
Separately, iron ore prices are down almost 35 percent from the August peak, which should also drive down the value of the Australian dollar from a trade balance perspective.
3. The risk-on environment will probably not last
Westpac expects the Eurozone bailout progress to falter in the coming weeks; it could come from low bank participation on the voluntary 50 percent haircut on Greek debt, slow bank recapitalization, or a low level of international (Chinese) support for the Eurozone bailout fund.
On Tuesday, the Eurozone situation already worsened from Greek Prime Minister George Papandreou's surprise referendum on the Eurozone-imposed Greek austerity measures.
In the U.S., the inability of lawmakers to come up with a credible plan to cut the long-term budget deficit is a concern.
Beginning this week, the Australian dollar is already fulfilling Westpac's outlook (published early Monday morning ET); the Australian dollar has plunged over 3 percent against the U.S. dollar.
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