If you’re a trader, then yesterday’s action in the currency markets was better than winning the Melbourne Cup. The surprise quarter point rate hike in the cash rate to 4.75% was followed by a swift and even bigger rise in variable mortgage rates by the Commonwealth Bank (ASX:CBA). The bankers move fast when chasing a dollar.
Traders – seeing that the banks improve net interest margins by raising rates on borrowers (but not raising rates for depositors) – bought the banks. Mind you, the bank stocks might not make good investments. To make that determination you’d have to look more closely at their balance sheets. But as a trade, the fact that short-term profits will be boosted is apparently enough to have a punt.
There are bigger implications for the rest of the market from yesterday’s rate rise; it’s just that no one really knows what they are yet. There are a few factors at work, though. First, taken by itself, the rate hike takes more money out of your pocket and puts it in the banks’ pockets. This means you have less money to buy other stuff from other businesses that are not banks (like retailers). Stay tuned later this week for a much more in-depth look at the state of Aussie retailing.
But from a top-down view, there’s more going on than just domestic interest rates. Tomorrow is the big day when the Federal Reserve announces just what it’s going to do to manipulate the stock market higher. It better be good (on the order of at least $100 billion a month in asset purchases) or markets will likely sell off.
It’s a fine line, though. You can see one scenario in which the Fed gets it just right (in terms of tone) and the U.S. dollar rallies as a result. But another possibility, one we consider more likely, is that the Fed confuses the dickens out of everyone and the move into tangible assets and emerging market equities accelerates (more of a migration than a trade).
This would see the Aussie dollar go well past parity on USD weakness. That might be even more of a short-term shock to Aussie exporters whose profits are affected by volatility in foreign exchange rates. By “shock,” we mean bearish.
Is it rash (and are we simply over caffeinated) to suggest the Aussie could appreciate by another 10% in short order versus the greenback? Maybe it IS rash. But then, we are talking about “the end of dollar hegemony.”
For a non-hyperbolic look at the markets, we’ll hit up our technical analyst Murray Dawes to see what he says. The forex markets are dominated by traders who use Fibonacci numbers to determine lines of resistance and support. Interest rates matter too. But fundamental arguments about a currency’s inherent worthlessness don’t tend to sway traders on a day-to-day basis, which is why currency moves are rarely dramatic – unless a fundamental loss of confidence in monetary and fiscal policy occurs in a given currency.
There are two early indicators, though, that the US dollar does not face run-of-the-mill risks at the moment. This means the moves that could result from a big fall in the dollar could be bigger, riskier, and potentially more profitable for adept traders than usual. So what are they?
The first indicator is that the investment/money management establishment is turning against the Fed and is increasingly aware that monetisation of debt (buying Treasuries with new money) is inflationary. Bond King Bill Gross told Reuters in an interview, “I think a 20 percent decline in the dollar is possible.”
Gross said it could happen in the next few years. He added that, “When a central bank prints trillions of dollars of checks, which is not necessarily what (a second round of quantitative easing) will do in terms of the amount, but if it gets into that territory – that is a debasement of the dollar in terms of the supply of dollars on a global basis.”
Judging by the silver and sugar markets, the dollar is losing value a more quickly than Gross reckons. Sugar has reached a 30-year high this week. Since their lows in May, raw sugar futures traded in New York are up 135%. Sugar now costs around 30 U.S. cents a pound.
That sounds cheap if you have a bunch of base metal shrapnel rattling around in your pocket. But in the emerging markets and developing world, inflation in sugar and grains prices hits discretionary income a lot harder…because food makes up the largest part of consumer expenses.
This is why, in last month’s issue of the Australian Wealth Gameplan, we argued that the currency wars are effectively over when countries must abandon competitive devaluation to fight domestic food and fuel inflation. You might not think that the RBA has to worry about this, given that the updated Index of Commodity prices released this week actually fell by 2.9% in Aussie dollar terms. But most of that fall was attributed to falling non-rural commodity prices like coal and iron ore.
The RBA must be worried that Fed action is stoking rampant commodity price inflation. It would not be alone in making that observation. For traders this is a golden speculative opportunity (literally and figuratively). For central banks, it’s a big headache. India’s central bank raised interest rates for the sixth time this year on Tuesday. It’s trying to contain food inflation – the first order consequence of out-of-control monetary policy before it becomes even more politically destabilising.
Of course rising commodity prices are not just determined by the value of the U.S. dollar in which their priced. The supply/demand dynamics of each market play a huge factor too. For sugar, traders are forecasting smaller-than-expected crops from major exporters. Prices are up.
You could safely make the argument that during the equities bull market from 1982-2000 there was chronic underinvestment in productive capacity in the commodities sector. This is one reason why it’s so hard to ramp up growth in commodities when demand resumes. Another obvious reason is that you have to find metals and plant crops and spend a lot of capital extracting scarce resources from the ground.
An even more bullish point (for resource speculators) is that the market capitalisation of the commodities sector (ex-oil) is pretty small compared to the rest of the market. There aren’t a lot of stocks to choose from and it’s mostly dominated by the big established producers. There are hundreds of tiny explorers that enjoy no analyst coverage and remain inaccessible to big institutional money.
Take the gold sector. The combined market capitalisation of North American listed companies is around US$25 billion. By comparison, the Big Four banks here in Australia have a combined market cap of just over AU$200 billion. The point: as investable asset class, gold stocks are a small group and thus should be highly responsive to even small changes in institutional asset allocation models that hedge against further U.S. dollar declines.
And gold may not even be the best metal going at the moment. Take a look at the chart below which we made this morning. This is the gold/silver ratio. It tells you the number of ounces silver it takes you to buy an ounce of gold. When the ratio declines, as it is now, it means either gold is weak or silver is going up faster than gold
Silver outperforming gold
Click here to enlarge
Gold hasn’t exactly been weak, mind you. It’s up three percent in the last thirty days and about thirty percent in the last year. But sliver is up nearly 30% in the last 30 days and nearly 52% in the last year. So what does that tell you?
Well, to us, it means commodity markets are pricing in further U.S. dollar declines. The risk to these recent moves is that their either unsustainable (for food prices, and on a political basis) or over-stretched. If the market is like a piece of elastic, where prices revert to the mean, then the above chart would tell you that silver is over-bought or gold is under-bought. Of course the ratio cold also move higher if gold stayed the same and sliver consolidated.
The mechanics of this price action is surely one subject to be covered at next week’s Gold Symposium in Sydney. If you’ve been a slacker and meant to sign up and haven’t, do so today, and make sure you get the discounted rate for Markets and Money readers. It’s not too late. There will be a lot of useful discussion what to expect in the year ahead as the Aussie goes past parity and the world’s central banks remonetise precious metals as a reserve asset.
Your risk is that that the election results in the U.S. may encourage traders that we have already seen the high water mark for U.S. fiscal irresponsibility. An improvement in the U.S. fiscal picture, coupled with a reigning in of the Federal Reserve’s destructive dollar policy, might reverse the trend in gold and silver prices for a bit.
But not for long, we reckon. Paper money not backed by metal is reverting to its inherent value. That is the primary trend driving all markets right now. It’s accounting for a huge variety of speculative opportunities. Our colleagues Kris, Alex, and Murray are loving it. Your editor…not so much.
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