Tension Rising Between Australia and China

Outside of the ethnic turmoil in China, there is another story that appears to be hitting the markets. Earlier today, Chinese authorities "detained" Rio Tinto's top iron ore negotiator on suspicion of espionage and stealing state secrets. This comes as a Shanghai paper reported that Chinese steel companies have belatedly agreed iron ore prices, accepting a 33% cut for six months, though other reports suggest Chinese negotiators continue to seek deeper price cuts. Recall as well that Rio Tinto balked at a $19.5 billion investment by a Chinese company (Chinalco) a few weeks ago. Chinese officials deny a connection between the detention of the negotiator and the belabored negotiations that failed to meet the June 30th deadline.

Our bullish outlook for the Australian dollar was in part predicated on its trade ties to China. While these events call that into question and may be a factor that has led to the Australian dollar's under-performance today, we think that market talk that China is canceling other investment projects in Australia are likely premature. We see little evidence for that, though the talk is making the rounds.

The Australian dollar's weakness is most likely a function of the pressure on commodity markets (our work shows a greater correlation between the Australian dollar and copper than gold), unwinding short-yen crosses, and some doubts about the global recovery story. A move above $0.7850 is needed to stabilize the tone, but this is likely to prove a bridge too far today. On the downside, the next objective is near the late May lows near $0.7740.