The Australian Dollar is Caught in a Currency Crossfire

In today’s Markets and Money we’re going to discuss the possible impact on Australia of a changing global monetary system. We say possible because no one really knows where this rabbit hole we’re heading down leads, so it’s all guesswork.

But perhaps yesterday gave us a sniff of what’s to come. The Australian dollar soared early in the day, heading towards US97.5 cents, but then plunged nearly US1 cent in the afternoon. It fell further overnight, and currently trades around US96.2 cents.

Why the wild swings?

Well, early in the day inflation data came out much higher than expected for the September quarter. It showed price rises of 1.2%, well above expectations of a 0.8% quarterly increase. Despite the fact that this represented a faster than expected decline in the purchasing power of the dollar, traders rushed to buy on the expectation that there would be no more interest rate cuts for some time.

Higher nominal interest rates relative to the rest of the world are bullish for a currency, so the Australian dollar soared on the news.

But then in the afternoon the old Chinese jitters came back into the market. Signs of tighter money market rates in China, along with a surging yen, spooked investors and the dollar plunged. At least that the story from the FX markets.

But it was probably something far simpler. As in…the Aussie dollar had rallied about 8% in the space of less than two months, and it was time for a pullback. That’s right, it was only a few months ago that the Aussie had breached US90 cents on the downside.

This type of volatility is extraordinary, but it’s become far more ordinary in the modern day degenerate financial world we’re in.

We think part of the reason for the Australian dollar’s wild swings is because it’s a derivate of the most important exchange rate in the world, the US dollar/Chinese yuan rate. And China artificially maintains this rate in order to gain trade advantages over the rest of the world via a weaker currency.

If China didn’t manipulate the exchange rate, the yuan would rise against the US dollar and the trade flows between the two countries would be completely different. If that were the case, then China wouldn’t be printing so much of its own currency to maintain the artificial exchange rate. And if it didn’t do this, there wouldn’t be so much fuel for the current credit boom that’s going on over there.

Linking it back to Australia, if there wasn’t a credit boom in China there wouldn’t be an iron ore boom here…or as large a property boom for that matter. Many Chinese citizens are looking to parley their success from punting on higher house prices in China by punting on higher house prices here. It’s all fuel for the fire.

International traders know the Australian dollar is a derivative of the USD/yuan phoney rate. They view Australia and the Aussie dollar as a proxy for what’s going on in China. So bad news in China means sell the Aussie dollar. For what it’s worth, we reckon there’s bad news coming up for China. Its property boom is again getting out of control, and China’s timid leadership will surely start to rein it in…again.

But the big question is, how long can China go on manipulating its exchange rate against the US dollar? The US continues to persist with very loose monetary policy, and via the currency peg China imports US monetary policy. The yuan has strengthened against the greenback a little over the past year – by around 2.6% – but not enough to stop the flow of excess liquidity into the Chinese economy.

As we discussed earlier this week, China is busy establishing bilateral swap lines with many of the world’s central banks so it can bypass the US dollar when conducting international trade. We don’t know what the ramifications of this will be once it’s set in motion, but you would have to expect it would strengthen the yuan against the greenback.

How would this impact on Australia’s economy?

Well, it would probably put an end to the Chinese credit bubble (which makes us wonder how slow China will be in actually instigating these bilateral trade routes) and transfer purchasing power to the Chinese household sector (via a stronger yuan relative to other global currencies). This would make foreign consumer goods cheaper and promote the long-awaited and much talked about rebalancing of the Chinese economy by promoting domestic demand.

Which is all good long term. But as we keep pointing out, such a rebalancing will see China’s economic growth fall sharply for at least a few quarters, and perhaps longer. This won’t be good for Australia and will put pressure on the Australian dollar.

But on the other side of the 20-cent piece, you have a much weaker greenback – assuming China stops trying to support it via the manipulated currency peg – which will provide support for the Aussie.

A sharply slowing China coupled with a higher Aussie dollar would be a double whammy and a nightmare outcome for Australia. It would crush our exports and the trade and current account deficit would widen considerably.

As the system degenerates, you’ll probably see both outcomes – a weak AND strong Aussie at different times. As a sign of this systemic degeneration, we think you’ll see global capital returning to the core, and the core of the system is US dollars. So a sharp rally in the US dollar just prior to its plunge against real tangible goods (i.e. major inflation) wouldn’t surprise us. Everything will move around wildly.

But nothing would surprise us over the next few years. We’re deep in the rabbit hole and no one really knows what’s going on. All you can really be certain of is that there will be a lot of volatility ahead…especially in the currency markets.

As for Australia, unfortunately we think there’s a high probability that China will run into problems with its Ponzi scheme very soon. As in by the end of the year. A lack of new credit of large enough magnitude to sustain the boom will trigger the problems, rather than a deliberate move to get out of the dollar.

From there is will be interesting to see China’s response in terms of maintaining its artificial peg to the dollar. Jim Rickards would say you’ll see a major escalation in the currency wars if economic growth in China slows markedly…it’s the only large economy in the world exhibiting decent growth.

As for Australia, we’re a mouse on a field of giants. The best we can do is try to keep out of the way. That will be difficult.  We’ll no doubt cop a few kicks as this game winds down.

Regards,

Greg Canavan+
for Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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