Reserve Bank of Australia (RBA) Board is set to meet on Tuesday June 5^th and the decision will be announced at 2:30 PM local time (12:30 AM EST). This month, the impact of RBA’s cash rate decision and statement will be felt not only by the Australian equity market but also by its currency.

RBA’s current cash rate is 3.75% and the consensus view is that RBA will leave it unchanged. However, the economic conditions of the country, her major trading partners and the world in general are weakening. Hence, the chance that RBA will surprise with a rate cut has increased. If that happens, then it will create tradable opportunities – bearish for its currency and, perhaps, bullish for its equities.

The European financial crisis has badly hit the sentiment and the Australian Investors’ Association (AIA) Investor Confidence Index is now down to 40.6, the lowest level recorded since March 2011. On Friday June 1^st, iShares MSCI Australia Index Fund (EWA) closed at 20.37 from the 2011 high of 28.35. Australian Dollar (AUD/USD) closed at 0.9695 against the US Dollar from the 2012 high of 1.0856. The S&P/ASX 200 index is down 10% from its 2012 high and may breach the 2011 low if the economy does not improve. Unlike, S&P 500 it never reclaimed more than 50% of the drop from 2007 high. So it is not surprising that Australian investor sentiment is taking a hit in the aftermath of the European crisis.

Australian economy is resource driven therefore it is also feeling a head-wind due to collapsing commodity prices and deteriorating Chinese economy.

Natural resources – iron ore, coal, gold, crude oil, natural gas, aluminum and copper – account for more than 54% of Australia’s export. China is her biggest trade partner and accounts for 24% of her exports. Iron ore and coal account for 68% of exports to China. But Chinese economy is hitting some serious bumps. The slowdown is leading to large stockpiles of iron ore at her ports and Chinese traders fear a repeat of repeat of 2008.

Singapore Mercantile Exchange’s global Metal Bulletin Iron Ore (MBIO) is also declining indicating that the demand for iron ore is going to worsen. Over the last five years, Australian Dollar has maintained a strong correlation with this index as shown by the weekly chart from of FXA (green) – an ETF for Australian Dollar – with MBIO index (red).

FXA is also strongly correlated with copper and the CRB index. Both are in serious decline, indicating that recessionary pressures are non-existent.

Here is FXA (black line) with copper (blue line):

And, here is FXA (black) with CRB Index (blue):

Inflation in Australia is 1.6%, lower than target of 2-3 percent. So RBA does have some room to cut rates.

In April, JP Morgan Australia estimated that RBA will trim rates in June. Various business leaders are urging for a rate cut to boost confidence and improve the economy. Economists are foreseeing a series of cuts by the end of the year that will take the rates down to 2.755. Some think it may go below 1.9%.

If RBA does surprise with a rate cut then chances are high that Aussie Dollar will decline against major currencies. The chart of AUD/USD charts also indicates that there is a greater likelihood Oct ’11 low of 0.9388 tested or broken than the May ’12 high of 1.0433 tested and taken out in the coming days. Currency ETF FXA is a proxy for Aussie Dollar.

There are many economic reasons for RBA to cut rates. It has also telegraphed a dovish intent for some time. A surprise cash rate cut will be bullish for EWA and bearish for FXA. But there is no guarantee that RBA will announce a rate cute tomorrow, in that case it will be a slow grind for few more weeks for EWA and FXA may even rise and test the resistence level created by AUD/USD parity.