Aussie Dollar in a Copper Cauldron!

I keep thinking that any day now the Australian dollar will take a dirt nap. It took one back in mid-2008, falling a stunning 39 percent in just three months in the midst of the credit crunch. This shows just how vulnerable the Aussie can be to a growth accident that slams the world economy; it is the premiere risk currency among the major dollar currency pairs.

Global growth is fading fast again, and copper seems to be highlighting that story. It could be lights out for the Aussie again if that’s the case.

As you can see in the chart below, the copper futures weekly uptrend line is broken, and the primary trend is down. The yellow rectangular box shows what happened in the midst of the great credit crunch of 2008.

And as you may know, copper is considered a key industrial metal; its price movement is often used as an indicator of the direction of growth in the global economy.

If you are a regular reader of Money and Markets, you likely know that China is the world’s largest consumer of copper. But the drop in prices has not come as a welcome development. This is because …

Copper Has Taken on an
Important Role in Financing

An increasing number of Chinese firms have been stockpiling the metal and using it as collateral — because the government’s measures to curb inflation have limited the firms’ access to credit. Such financing links the price of copper to other key elements of the Chinese economy, including the growing speculative real estate bubble.

China’s tightening monetary policy has made it more difficult to access credit through official channels. As a result, Chinese small- and medium-size enterprises have increasingly turned to copper for use as collateral in loans, which are then funneled into other sectors of the economy.

The falling price of copper means that the collateral initially put up for the loans in yuan is no longer worth what it once was, decreasing the likelihood that the borrower will be able to pay back the loan.

If firms default on debts, then others connected in the chain will default — and determining where loans have been invested is nearly impossible.

Banks and state-owned enterprises (SOEs) are also potentially vulnerable. A high number of SOEs have also used copper as collateral. These firms are often involved in the real estate sector — even if their primary function is not always directly linked to it — and are therefore exposed to the country’s growing real estate bubble.

The government would bail out the more politically favored SOEs if necessary. But that would leave fewer resources to be allocated to the private sector, which is crucially important to China’s growth.

It is all about feedback loops. And …

This One Could Turn Quite Vicious
for China and In Turn the Aussie Dollar!

The Australian economy is highly dependent on China for its own growth. For a while now, I’ve been saying that Australia has effectively become a satellite country of China. Take a look at this chart showing China’s imports from Australia thru September.

Lower copper prices could put a real damper on Australia’s growth. Another major hit is already in play: Falling consumer demand from the euro zone and the U.S.

And if the bubble were to finally pop in Chinese real estate, it would be much uglier indeed.

So we have the potential for real demand in copper and other commodities to decline sharply. Toss in the added thumping from the internal Chinese speculation, which would likely push the metal back toward its credit crunch low, and you get another 50 percent decline in the red metal.

And guess which currency has been tightly correlated to the price of copper over the last few years? If you said the Aussie dollar, you were right on!

There are two key takeaways from the following chart of the Aussie/U.S. dollar vs. copper:

1) There is a very large divergence between the two price series; and

2) In the past the series have been highly correlated.

I suspect we will see a big move one way or the other. It could be copper soars. But for now, I’m betting the Aussie tanks.

Stay tuned.

Jack