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A strange thing has been happening to the Aussie. Normally it resides at the very risky end of the forex spectrum and moves closely with risk assets. Over the last 12 months it has had an 80% positive correlation with the S&P 500, which means that it has moved 80% of the time in the same direction as the US stock index.

That correlation held strong until the start of this year when it started to fall. In February it fell to 70% and since the start of March it has fallen to 65%. This is evident in the chart, as you can see below. The Aussie has fallen while the S&P 500 has been rising.






So why has this divergence happened and what does it mean going forward? The major factor weighing on the Aussie right now is China. This is Australia's biggest trading partner by far, and Chinese demand for Australian minerals and commodities have helped boost Australia's terms of trade position and has kept interest rates relatively high over the last few years (even with recent cuts), which has fed through to a stronger currency.

However, that support is eroding as China's growth for 2012 is set to slow to 7.5% per year in 2012 from 8.9% in 2011, its manufacturing PMI as measured by HSBC/ Markit remains below the crucial 50 level and we don't know yet if growth has reached a bottom. Added to that the People's Bank of China hasn't stepped in to loosen monetary conditions, which usually gives the Aussie a boost, as Beijing remains concerned about inflation pressures.

So that leaves the Aussie rudderless on rough FX seas. As long as China was moving along nicely then it could rally with the S&P, but now it is falling alongside the dollar, suggesting that recent weakness in AUDUSD is down to weakness in the Aussie fundamentals.

The Aussie/ S&P relationship is also important for US stocks. The S&P has surged to four year highs this quarter on the back of stronger US economic data. If stocks are to continue to push higher then the US economy needs to keep growing. The S&P has proven extremely resilient to Chinese weakness, yet surely a slowdown in China could de-rail the US economy? Some argue not, since the US is still the world's most important source of demand. Others believe that China could bounce back and follow the US higher with a lag, so the SPX 500 and AUDUSD correlation may not be dead and buried yet.

But it is for the short-term and there are a couple of things to look out. For both the Aussie and the SPX US and Chinese economic data in the coming weeks is going to be vital to drive market moves. On Saturday we should see the release of the Chinese official PMI survey, which may fall along with the HSBC version. If this happens then AUDUSD is vulnerable to breaching the 1.0380 - 200-day moving average and a key support level. If this is happens then it could trigger further selling and we believe it would open the way for a further move lower towards parity on a longer-term basis.





EURAUD has also reached fresh 2012 highs, which now leaves 1.30 in sight. Right now it looks like the Aussie is weakening on a broad-based basis, which could give this cross another leg higher. The daily RSI chart is also pointing to further upward momentum for this cross.



Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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