This sharp decline in the Australian dollar may significantly delay RBA rate cuts, due to its inflationary impact.

The Australian dollar, along with most other currencies and the major commodities, has fallen badly over the last three weeks against the US dollar. It seems we are experiencing a sell anything that benefited from prior US dollar weakness theme. This is a massive squaring up of every long bet in any market that was held against the US dollar. Perhaps there is a story behind the scenes that we may one day discover, but in dealing with markets at the moment, there is no sense standing in front of a freight train. It is a question of momentum.

• Merrill Lynch & Co’s writes down US$18.7 billion over just twelve months.
• Further financial collapses and retrenchment in consumption are a given.
• Dow Jones 11,100/11,000, its better if the support holds.

With Merrill Lynch & Co’s write downs rising to US$18.7 billion over just twelve months, with the latest quarterly addition being US$5.7 billion, the writing is on the wall, and the pavement of Wall Street, that things in the financial district may just still get worse before they get better. Share holder dilution as a means of raising fresh capital to stay afloat can only go so far for any of the major houses, after that comes further debt raisings. The spreads and very high rates of interest the investment banks would now have to pay to raise further funds, can best be described as problematic. So much for the top end of town.

• US recession to intensify: Risk US Q4 GDP -2.0%
• A sharp pullback after the rally, but still perhaps a bull trend if 11,000 holds
• US dollar to top out very quickly now, and next down move could be sharp
• Gold and Oil forming a base to again rally, but only Gold will make new highs

The US recession looks set to intensify in this second half of 2008. With initial jobless claims coming in at 406k, and existing home sales down 2.6% the trend for the US economy remains as expected, entrenched to the downside. It is possible we are about to see the capitulation wave of selling that often comes in the final stages of any market down-turn, over the next six months, in US home values. Though the end of the decline may be only six months away, the pain could be severe. US home values may fall a further 5% to 15% in this period, perhaps into January/February worst case. The additional strain on the financial sector would see several more US financial houses in trouble. For the economy in general the potential for a severe deepening recession is clear to see.

For the first time this year, there is cause to consider the possibility that the absolute low in equity markets, both in the US and Australia, has just been seen.

Please do not take this as in any way suggesting the US and Australian economies have bottomed, far from it!

A recession is still very much on the cards for the US, and our central scenario there remains stagnant growth throughout 2008, and into the first three quarters of 2009. Most commentators now agree with our long held view that the US economy will begin to recover 6-12 months after property prices stabilise. The most likely scenario is that US property prices will have run their course to the downside by the end of this year. The US will continue to see consumers cutting back, high oil prices as their currency continues to fall, and extremely difficult credit conditions. The US will however at the end of 2009, worst case early 2010, begin to turn around, as long as the Fed can stop itself from hiking due to inflationary pressures that are beyond its control.

The Australian dollar looks set to strike toward Parity to the US dollar over the next 1-3 weeks, despite the increasing likelihood of the “recession we do not have to have”.

Sonray was the first to highlight the potential for the “recession we do not have to have” in Australia toward year end in a report published January 14th.  At the time new car sales were at record highs, but we noted the risk of Australia following a similar path to that of the US, that being vulnerability in property prices and our non-consensus view that retail sales could be soft in H1.

The Australian dollar is again on its way to loftier regions. As forecast in 2006 at 76 cents, the Australian dollar is expected to achieve parity to the US dollar in this fine year 2008.

The reasons are the same as they were back in 2006;

1. China/Asia economic boom creating an insatiable demand for our commodities.
2. The value of those commodities maintaining a bull trend bias for the same reasons.
3. Reserve Bank of Australia setting rates at very high levels by international standards.
4. Sophisticated financial markets and legal system allows Australia to be seen as a long term quality asset of global portfolios.
5. A long term decline of the US dollar which remains in full swing.

All of the above forces are likely to remain in place for some time. Therefore the Australian dollar can be expected to achieve our constantly forecast targets, including the seemingly more distant potential of a move to US$1.08 in 2009.

And a spectacular day it is! Full of opportunity!

Well someone has to put a positive tone on things, and the reality is that in financial market trading terms, it just doesn’t get any better than this! Yes there are challenges confronting the US economy which are unlikely to be overcome any time soon, and Oil is continuing to climb as we achieve our target set some time back of US$147, but if you are in the business of managing financial market risk, and trading financial markets for profit, then the major price shifts in all markets are a significant opportunity.

For Australia, “the Recession we do not have to have”, is a phrase I used at the start of the year to suggest what could be the case in this second half of 2008. It was not a popular view then, and still isn’t, but it is always important to identify where the risk is, and it is not consensus out-performance by any means. The Reserve Bank of Australia deserves a red card, to perhaps be allowed back on the field next game. As I suggested many months ago, if we do experience a recession in Australia it will largely be because the RBA over cooked interest rates. The recession risk also has to do with the psychological transference of economic belt tightening from the US to Australia due to our high degree of cultural and business linkage.

Time to Batten Down the Hatches!

Reality Check:

1. US Recession Unavoidable, and stagnant growth could remain for up to 18 months
2. Rest‐of‐World will fare better but also at a reduced speed
3. Demand for commodities will nonetheless continue to increase
4. Oil will remain above 110, perhaps above 130. Tests toward 150 or higher are likely by year end
5. Financial sector will continue to reel from falling US home prices. In fact the worst of the fallout among financial institutions has yet to be seen. The second wave of right downs in H2 could be as severe, or larger than that already seen.

Market Outlook:

The potential target for Oil on the next run up is US$147. Toward the magical US$150 mark would be simply too politically volatile to contemplate at this time. Hence any speculative longs, especially the very large fund players who need liquidity to exit with high profit, are likely to be selling into the euphoria that may grip an approach toward US$150. Certainly new highs are likely to see a fresh speculative buying wave that would provide both higher prices and high volume in the short run.