Australian Dollar to Fall on Fading EU Optimism, RBA Rate Cut Risk

Fundamental Forecast for Australian Dollar: Bearish

• Australian Dollar Outperforms as EU Unveils Crisis-Fighting Effort
• Futures Positioning Hints Australian Dollar Extremes Being Unwound
• Stock Prices Remain the Most Prominent Driver of Australian Dollar

The Australian Dollar outperformed last week, sent higher by an impressive 1.7 percent against its US namesake amid a swell in risk appetite after EU leaders delivered an unexpectedly forceful response to the region's debt and banking crisis. Policymakers agreed to create a joint bank supervision scheme, to be established by the end of the year. Once that is operational, the EFSF/ESM bailout funds will be given authority to recapitalize banks directly without funneling funds through the governments of member states (which otherwise increases sovereign debt levels). The terms of Spain's bank rescue will also be amended such that the EFSF/ESM funds will not gain seniority status. This would have given them priority to get paid out ahead of the country's other creditors in the event of default and restructuring (which would discourage private buying of Spanish bonds, driving borrowing costs higher).

The week ahead is likely to prove far more challenging. Investors' expectations for the EU summit were set exceptionally low, so overcoming them was not a particularly challenging endeavor. Furthermore, the agreed-upon measures do little to alter the near-term reality that prevailed before the summit. Indeed, Spain will still get its banking bailout passed through the sovereign channel, which will increase the size of the government's obligations. The empowerment of the EFSF/ESM funds to fund banks directly will not be available until year-end, and only in if negotiations on the banking union proceed as planned. That leaves the region with no more of a firewall against sovereign jitters than before for at best six months.

Finally, the firepower available to the EFSF has not been increased, meaning it would have to borrow in the markets if it were to be called upon to meet its expanded mandate. The fund can now borrow at 2.75 percent for 10 years, a vast improvement over Spain's 6.33 percent and Italy's 5.82 percent over the same period. Markets are surely not blind to the new credit risks facing the fund as part of its enhanced responsibilities however and will no doubt demand a higher return before long. If the EFSF itself faces a surge in borrowing costs, governments will need to pony up a lot more cash or the entire arrangement will once again unravel. On balance, this opens the door for financial markets to reverse course as the details of the EU leaders' outing are digested, reversing the surge in risk appetite and pulling the sentiment-anchored Australian Dollar lower along with stock prices.

Downside pressure may be amplified if the Reserve Bank of Australia opts to deliver another interest rate cut at next week's policy meeting. Economists' expectations suggest Glenn Stevens and company will maintain the benchmark lending rate at 3.5 percent this time around. Investors' priced-in expectations are in line with that assessment, revealing a mere 16 percent probability of another 25bps cut (according to data compiled by Credit Suisse). That leaves the door open for sharp selling pressure in the event of a dovish surprise. A deepening slump in Australia's economic outlook by way of eroding export demand suggests the RBA has scope to act. Economic data tracking the performance of China - Australia's top export market - and the Asia Pacific region as a while released since the central bank's June meeting has pointed to continued weakness. Data from the Eurozone has likewise darkened, meaning the outlook for Australia's raw materials in Asia will remain lackluster as the region's exporters grapple with slumping demand in a critical overseas market.-IS