Will FXA Follow FXI Down?

March 30, 2012

With China’s economy clearly slowing, is the party about to be over for the Australian dollar?

Since the end of 2008, the CurrencyShares Australian Dollar ETF (NYSEArca: FXA), a long Aussie dollar bet relative to the greenback, has returned over 65 percent, making the Aussie dollar one of the world’s best-performing currencies.

That’s been music to investors’ ears.

But with signs of Chinese economic fragility appearing and China’s stock market reflecting the slowdown, isn’t it high time for FXA to get with the program and start correcting downward?

A little background is in order.

Australia’s resource-rich economy has benefited hugely from China’s rapid expansion. It’s pretty much next door to China, and it helps that iron ore, lead and coal—three of Australia’s most abundant natural resources—also happen to be those in high demand in China.

This natural trading partnership has helped drive the price of the Australian dollar higher and buoyed the entire Australian economy.

Prior to the middle of last year, the Aussie dollar and Chinese stock market moved in virtual lock step with each other, as the chart below comparing FXA in pink and the iShares FTSE China 25 Index Fund (NYSEArca: FXI) in green clearly demonstrates.

FXA vs FXI

But something obviously broke in 2011, as the Chinese stock market fell roughly 20 percent.

So, what does this say about the future of the Australian economy, and the Aussie dollar?

It seems the writing is on the wall. Based on that chart, you can see that the Aussie dollar has lagged the correction in Chinese equities, sustaining its upward momentum in the face of a clearly deteriorating Chinese equities market.

Now that evidence of a Chinese economic slowdown has started to reveal itself in the country’s economic data, one has to wonder if it’s well past time for FXA to pay the piper.

After all, the increase in Australian exports to China in the past 20 years has been magnificent: Australian exports have seen a dramatic push from $1.6 billion to China in 1990-1991 to $70.5 billion in 2010.

Making matters worse, mining now constitutes 5.6 percent of Australian gross domestic product, further highlighting the country’s economic reliance on Chinese demand.

While 5.6 percent of GDP may not seem like a lot, China is far and away the country’s largest export market for the key resources mentioned above. That means even a marginal decline in Chinese demand for these materials could have a swift ripple effect.

To me, it’s telling that Australian manufacturers marched to Sydney this week to bemoan the lack of attention paid to industries other than commodities.

It should come as no surprise then that any perceived slowdown in the Chinese economy would deal a major blow to the perception of economic sustainability in Australia.

Just look at the performance of FXA over the past month in the chart below: It sure seems like the market is starting to wake up to this reality.

FXA Total Return

For investors worried about the knock-on effects of a Chinese slowdown on the Australian dollar, there are different options for protecting yourself.

The first, most obvious, choice is shorting FXA.

Another, less risky, option is simply clearing any Australian exposure out of your portfolio.

Finally, for those looking for a pairs trade, going long FXI and short FXA could work, should the gap in performance between FXA and FXI close.

Regardless of what you decide, you’ve been warned, so don’t be left “spitting the dummy” should the high-flying FXA crash and burn.

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