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Don’t buy the recent bullishness on AUD

A bout of bullishness has seen the AUD rise since early last month, yet the fundamental problems facing the Australian economy – falling export prices for commodities and an overvalued currency that prevents companies from moving higher up the value-added scale – are likely to see the currency fall over time.

In order to understand why the AUD is likely to fall, let's first take a look at why itrose so much over the last several years.

A lot of the AUD's rise comes down to the improvement in the country's terms of trade. "Terms of trade" is an economic concept that refers to the price of what a country exports relative to the price of what it imports.

(Read more: Australia's inflation spikecreates dilemma for central bank)

For example,Australia exports coal, among other things, and buys TV sets from Korea. Since 2005 the price of a 32" TV set has come down from $2,600 to less than $340.Meanwhile, the price of a ton of coal has risen by 60 percent, from $50 to $80.As a result, back in 2005 Australia had to export 50 tons of coal to buy one TV set and now it only has to export four tons. Thus, it's no surprise that the AUD appreciated from around 800 KRW in 2005 to 1,200 KRW in 2012.

However, coal prices have been coming down recently and as a result the AUD is starting to weaken against KRW and other currencies.

In graph #1, the red line is Australia's overall terms of trade as calculated by the Reserve Bank of Australia (RBA), and the blue line is AUD/USD. As you can see, this terms of trade effect drove the Australian dollar higher over the last several years, but recently has started to turn around. Unless the terms of trade begins to improve again, I don't think AUD will be able to rally significantly.

The price of the commodities that Australia exports depends a lot on what happens in China, both because China is the main market for Australia's commodity exports and sets the global price for these products. The outlook here isn't promising. For example,graph 2 shows Chinese coal inventories –the red line – are at a record level, while the price of Australia's exported coal – the blue line – is down 13 percent from a year ago.

It's a similar story with iron ore: China's iron ore inventories are also at a record level,while the price of iron ore exported to China is down 20 percent. As China's government succeeds in restructuring the economy away from investment and towards domestic demand, I think it's inevitable that China's demand for Australia's natural resources should slow and the prices of these commodities should decline.

(Read more: Is the worst over for the Aussie dollar?)

Now, the AUD has recovered to some degree recently. Just in the last few days the RBA changed its tone from its December meeting – the statement following the February meeting stopped implying that rate cuts were possible and that the currency was overvalued. That surprised me: the AUD trade-weighted index – that is, the value of the AUD against the currencies of Australia's major trading partners – has declined less than 2 percent since the December meeting. I don't think that's a major change,especially when the currency is still overvalued by around 25 percent,according to the OECD.

We've continued to see companies shutting down operations in Australia because it's just not a competitive place to produce.Just in December, RBA Gov. Stevens said he thought the currency should be closer to 85 cents (it's currently around 90 cents). I don't see what should've changed his mind since then, except perhaps a rise in inflation to the top half of his target band. I think he's likely to get his wish at some point as I seethe AUD declining against many of its counterparts.

However, it might take some time for AUD to fall further against the USD. As you can see from graph 3, the AUD has been tracking the difference between Australian and U.S. 10-year bond yields, the red line. As U.S. bond yields fall, the USD loses some of its interest rate support against the relatively high-yielding AUD.

Thus, I think we would probably have to see a turnaround in U.S. bond yields before we get a significant fall in the AUD/USD. I think it will come as the Federal Reserve continues to taper off its bond purchases, but it may take time.

(Read more: Australia's jobs picture keeps getting uglier)

To avoid that possibility, you might want to take a look at the AUD/NZD. Although a lot of the difference in monetary policy between the two countries is already priced in, I think there's probably still more to go and the NZD can appreciate further against the AUD. The GBP/AUD also looks promising given that the aims of the monetary authorities are likely to diverge.

The author is the Global Head of FX Strategy at IronFX Global, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.

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