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Australian Dollar Dropped by Chinese Data as World's Second Largest Economy Struggles

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- AUD slides as Chinese trade data suggests economy struggling. 

- Economic woes come as AUD grapples with soured RBA outlook.

- CBA says AUD to hold 0.70 ahead of jobs data but risk to downside.

-Westpac remains seller of AUD, looking for three RBA cuts to weigh.

The Australian Dollar slumped into the new week Monday after official data revealed a surprise and steep fall in the value of Chinese goods imports took place last month, stoking fears for the health of the world's second largest economy and putting the Aussie under pressure again.

Monday's losses beat the AUD/USD rate back from a two-month high and helped rescue the Pound-to-Australian-Dollar rate from what were the lowest levels since the beginning of April, although it remains to be seen whether either exchange rate will maintain their newfound trajectories.

China's trade surplus rose sharply during May thanks to an export trade with the rest of the world that rose by 1.1% in U.S. Dollar terms when compared with the same period one year ago, and due to a steep 8.5% fall in imports. This drove the trade surplus to $279 bn in May, from $94 bn previously.

"The weakness in imports will once again renew concerns about China's economy especially given the complicated path in delivering a US-China trade deal. We look for further weakness ahead as indicated by weakening PMIs among China's key trading partners," says Mark McCormick, head of FX strategy at TD Securities.

Trade balance data is normally watched closely by investors because it reflects real world supply and demand for a currency but Monday's figures were useful for a different reason in that they appear to reveal a Chinese domestic economy that is struggling in the face of President Donald Trump's trade war.

Above: Chinese imports by category. Source: Capital Economics.

China's economy has been creaking since August 2018 beneath the weight of White House tariffs on U.S. imports of Chinese goods that are still rising.

Trump lifted from 10% to 25% the tariff levied on imports of some $200 bn but there is another $300 bn of annual Chinese exports to the U.S. that is also set to be hit with a 25% tariff.

For Australia the impact of this tariff fight is two-fold in that economic weakness in China has potential to hit demand for, and reduce prices of, Australia's commodity exports.

The Aussie also suffers from the trade conflict because of the impact it's had on the Renminbi, because the large bilateral trade flow between both economies means the two currencies share a strong positive correlation.

"Heightened China-US trade tensions led to a sharp rise in USD/CNY," says Kevin Xie, an economist at Commonwealth Bank of Australia. "A lower CNY would offset some of Chinese exporters’ pressure amid the slower global growth prospectsand worsening China-US relations."

Above: AUD/USD rate shown at daily intervals, alongside USD/CNH rate (orange). 

The USD/CNH rate has risen 1.2% thus far in 2019 and the AUD/USD rate has fallen 1.2%, demonstrating the strong correlation between the two. 

Losses for both currencies since the beginning of the tariff fight have been substantial, with the USD/CNH pair up by 8.7% in the last 12 months and the AUD/USD rate down 8.3%.

Despite this, there is still scope for the trade war between the U.S. and China to do more damage to the global economy as well as to the Renminbi and Australian Dollar at the same time.

The tariff fight escalated last month as the White House lifted tariffs for the first time since summer 2018 and now, with each side deploying so-called blacklists against companies headquartered in the other's countries, it's on the verge of becoming an all-out economic conflict.

"The continued fall in imports underlines that domestic demand is lacklustre. Looking ahead, we now expect all US imports from China to be subject to a 25% tariff by early next year," says Marcel Thieliant at Capital Economics. "Meanwhile, China is mulling restrictions on rare earth exports, blacklisting US firms and discouraging Chinese citizens from visiting the US or studying there. The upshot is that the outlook for trade remains bleak."

Above: Pound-to-Australian-Dollar rate shown at daily intervals.

Monday's Chinese trade data comes at a time when the Australian Dollar is grappling with the fallout from a darkening outlook for Reserve Bank of Australia (RBA) interest rate policy, which has already seen the bank cut its interest rate to a new record low of 1.25% this year.

RBA policymakers have been battling inflation that is below the 2%-to-3% target for a number of years now only now the domestic and global economies are slowing, depriving the bank of the increased labour demand thought to be needed in order to lift workers' wages and generate higher inflation pressures.

Financial markets are now betting the RBA will cut its interest rate again in August and, potentially, a third time in November. The overnight-index-swap-implied cash rate for Tuesday 06 August, the date of the RBA's meeting for that month, reached 0.99% last Friday which just below the 1% level that would prevail if the bank did cut again. The November 05 rate was 0.84%.

"A$ rallies should be capped by RBA rate cuts in June and August and by the deterioration in US-China trade relations, but with OIS markets already priced for a sub-1% cash rate by 2020, we see AUD/USD only down to 0.68 by Sep," says Tim Riddell, a macro strategist at Westpac.

Above: AUD/USD rate shown at daily intervals.

Markets care about the Reserve Bank story because changes in interest rates, as well as the outlook for them, can have a significant influence over international capital flows as well as speculative short-term trading activity.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

Westpac, one of Australia's four largest lenders, has told institutional clients they should sell the Aussie against the U.S. Dollar because it's likely to fall to fresh lows before the year is out. The bank forecast three RBA rate cuts this year and noted at the time that not all of these have been fully priced into the Aussie.

"AUD/USD will continue to trade around 0.7000 this week as USD remains heavy. However, AUD could briefly fall on Thursday if the Australian unemployment rate stays at 5.2% as we expect. The RBA believes that the unemployment rate needs to move below 5% to reduce spare capacity in the labour market and boost inflation. On the flip side, an unemployment rate above 5% will warrant further cuts to the cash rate in both the market’s view, and the RBA’s view," says Richard Grace at Commonwealth Bank of Australia.

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