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Aussie in for Rough Times

NEW YORK ( TheStreet) -- The massive rally in the Australian dollar since the end of 2008 has taken a major turn in recent weeks, and a confluence of fundamental factors (both internal and external) suggest that this bearish run will continue.

Price moves in currencies tend to slow during the summer, but this year has been different, as implied volatility in the AUD/USD has hit highs of 15.5%. In early May, I warned of this potential weakness, so at this stage it is important to revisit the bearish case for the currency to see if these declines can continue.

Three separate factors are currently seen moving markets: Unstable credit conditions in China, a possible near-term tapering in quantitative easing stimulus from the US, and the broad expectation that the Reserve Bank of Australia will continue with further interest rate reductions before the end of this year.

So while some sections in the market might be looking at recent Aussie weakness as a new opportunity to buy the currency, there is not much in the fundamental picture to suggest a bullish reversal will be seen any time soon.

At the central bank level, markets are pricing in another 40 basis points in interest rate reductions from the RBA. This would take the country's official cash rate to a new all-time low (from its current levels at 2.75%) and take away some of the relative yield advantage that accompanies long positions in the Australian dollar.

If these expectations turn out to be accurate, the Aussie will lose its position as the highest-yielding currency amongst the majors (overtaken by the currency's counterpart in New Zealand).

At the same time, we are seeing markets reposition themselves for changes in policy by the Federal Reserve. Reduced monetary injections from the Fed could now come as early as September, and this brings with it a supportive climate for the U.S. dollar.

This also suggests that yearly lows in currency pairs like the AUD/USD haven't yet arrived. So, while the recent declines in the Aussie have been drastic, there aren't many reasons to believe we'll see significant bounces from current levels.
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