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How to (Carefully) Play the Aussie Dollar Short Trade—Searching for Alpha for December 2013

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Referring to the Australian dollar short trade in a recent article, Forbes magazine called it the next “Big Short,” in deference to the Michael Lewis book about the 2008 mortgage crisis. But I wouldn’t be quick to bet on the downtrend in the Aussie dollar just yet. 

There are lots of fundamental reasons why the Aussie dollar has been in a freefall for most of the year. The mining boom has slumped, leaving the commodity-dependent Australian economy in a bind. The Chinese economy, which typically imports vast amounts of Aussie raw materials, has slowed. Growing budget deficits and political instability has also clouded the outlook for the country. Word that George Soros started shorting the Aussie currency in late Spring added to the already bearish tone of the market. 

The weakness in the Aussie dollar was further highlighted in a recent Goldman Sachs report.  As one of their top trading ideas of 2014, the bank recommended last week that investors buy the S&P 500 index while shorting the Australian currency. 

The foundation for this idea is Goldman’s belief in the acceleration of U.S. economic growth. The short Aussie position is meant to hedge the trade against rising U.S. interest rates.

Although I find the fundamental logic for this trade compelling, I would strongly suggest caution. For starters, the leading short Aussie dollar ETF (CROC) has already surged 20% this year. Fears of a recession in Australia have yet to come to pass, which may indicate that rate cuts have run their course. The best way to address this trade may be to simply wait for a rebound before establishing a position, or to investigate the plethora of actively managed currency or managed futures funds that are active in the commodity currency space.

Above all, don’t play too large.  Currency markets are treacherous, and a small wager can be more easily maintained over the next 12-18 months.

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