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In a move that caught many traders off guard, the Reserve Bank of Australia (RBA) decided to cut its cash rate from 4.25% to 3.75% in its rate statement yesterday.

Most market players were only expecting a 0.25%, but apparently, the RBA had other things in mind.

Citing the slowdown in China and Europe’s never-ending problems, the RBA confirmed Australia’s vulnerability to external risks as one of the reasons behind its move.

Of course, internally, Australia has a couple of headaches to deal with as well. According to RBA Governor Glenn Stevens, output was “somewhat below trend” over the past year, and the high exchange rate hasn’t helped.

As I mentioned in my preview of the RBA interest rate statement, some of Australia’s trade-related industries have been struggling to compete in the global markets, and the Aussie’s recent strength is partially to blame.

Stevens also made it a point to mention that the housing market has been soft in recent months.

As a matter of fact, just a few hours before the rate statement, we got a grim reminder of just how weak it has become as the quarterly house price index revealed a 1.1% decline in house prices in Q1 2012, following the 0.7% slide in Q4 2011.

Most importantly, inflation hasn’t turned out to be the problem that the RBA thought it would be. And perhaps this was the biggest factor in the RBA’s decision to slash rates by 0.50%.

Why bother cutting rates 0.25% at a time when inflation isn’t posing a threat?

Naturally, the markets reacted very bearishly for the Aussie after the surprise move. Actually, the resulting price action pretty much-matched scenario 2 in the preview that I wrote yesterday, as AUD/USD staged a dramatic 100-pip drop.

With all the negative press surrounding the Australian dollar, does this mean the currency will continue to fall in the longer term?

Not necessarily. In fact, I’m torn between two points of view.

AUD/USD 4-Hour Chart

Bullish POV: Support at 1.0250 will hold and AUD/USD will head to 1.0500

On the one hand, even though it has slowed down, China’s growth prospects are nothing to scoff at. Yesterday, the Chinese NBS manufacturing PMI rose to 53.3 in April from 53.1 in March.

It’s a bit lower than the 53.6 median forecasts by Bloomberg, but it suggests that the Chinese economy has “bottomed out” during the first quarter of this year.

The components of the manufacturing PMI were strong. Exports climbed to 52.2 from 51.9 while factory output surged to 57.2 from 55.2.

Since China is one of Australia’s major trading partners, strength in the Chinese economy usually translates to increased demand for Australia’s exports.

Bearish POV: Support at 1.0250 will break and AUD/USD will fall to parity

On the other hand, in addition to the surprise rate cut, the euro zone’s debt situation could lead to another bout of risk aversion.

Many analysts, including myself, have speculated that Spain could end up as the next Ireland. I talked about this heavily in my post yesterday. This is of course bearish for the Aussie.

There’s also the old adage in the trading world that says “Sell in May, and go away.”

This refers to the belief that investors usually cash in their investments in May so that they can take the June to September summer months off.

Going by this adage, there is a chance that we’ll see the Aussie fall further as traders continue to take profit on its strong rally during the first half of the year.

We’ll see more data from Australia in the coming days and weeks, but given this new development, where do you think the Aussie is headed? Are you bullish or bearish on the currency?