Yesterday, Glenn Stevens at the Reserve Bank of Australia did what was expected and kept interest rates on hold. And absent any major shock to the economy, rates will remain on hold for some time to come. But if you read between the lines, Stevens must be getting just a little concerned about the ability of monetary policy to haul the economy back into healthy and sustainable growth.
From his statement yesterday:
‘Financial conditions overall remain very accommodative. Long-term interest rates and risk spreads remain low. Emerging market economies are once again receiving capital inflows. Volatility in many financial prices is currently unusually low. Markets appear to be attaching a very low probability to any rise in global interest rates over the period ahead.
‘Moderate growth has been occurring in consumer demand. A strong expansion in housing construction is now under way. At the same time, resources sector investment spending is starting to decline significantly. Signs of improvement in investment intentions in some other sectors are emerging, but these plans remain tentative as firms wait for more evidence of improved conditions before committing to significant expansion. Public spending is scheduled to be subdued. Overall, the Bank still expects growth to be a little below trend over the year ahead.’
In other words, money is everywhere and easy. These financial conditions *should* generate strong economic activity. But they’re not. Instead, consumer demand is only moderate (and could get worse if sentiment readings don’t improve); resource sector spending will drop dramatically this financial year, with only tentative plans to fill this investment hole. And the government is trying (badly) to fix a structurally weak budget.
Put another way, interest rates are at historic lows, and economic growth looks like it will remain below trend this year. The terms of trade (which has a major impact on national incomes) is under pressure and our Aussie dollar remains stubbornly high.
On a positive note, China is so far managing its downturn well. Targeted stimulus seems to be keeping activity elevated. The official manufacturing PMI for June came in at 51, up from 50.8 in May (a reading over 50 indicates expansion). Activity isn’t strong, but it’s not weak either.
This is probably why the dollar remains so strong in the face of a falling terms of trade. Add to that Japan’s grand monetary experiment, which is fuelling demand for the Aussie from yield starved Japanese savers, and you have a dollar that ‘remains high by historical standards’, as the RBA put it yesterday.
Well, it’s even higher after overnight trading action. As you can see in the chart below, the Australian dollar popped last night and is now set to breach 95 US cents. The chorus of parity callers will now grow louder. But I think this rally will run out of steam before it gets there. Then the Aussie will be a sell again.
Here comes the parity chorus
click to enlarge
I’m not sure why the dollar spiked so much. Was it the RBA leaving rates on hold (as expected) or was it China’s improving manufacturing data (which was also expected)? Who knows, maybe it just reflects a weaker greenback?
The Financial Review offers an innovative reason for the dollar to maintain its strength. Apparently the dollar will benefit from today’s expected trade deficit. According to the paper, ‘the local currency could find added support in Australian trade data as the rising volumes of exports comes on stream, suggesting more offshore investors are having to buy the local currency, and therefore leading to a widening of the trade deficit.’
What the? So a widening trade deficit is now good for a currency? Well, in these no-risk markets, just about anything makes sense.
I prefer to think of it like this. The Australian dollar is a high yielding currency. That’s because it’s risky (our net foreign debt levels are up to $855 billion) and we are overly reliant on one customer (China now takes in around 40% of our exports). When no one cares about risk, you can’t get enough Aussie dollars…when risk becomes an issue, you can’t dump them quick enough. End of story.
Speaking of risk, remember how the Bank for International Settlements (BIS) came out on the weekend warning of euphoric markets? Here’s the excerpt:
‘The overall impression is that the global economy is healing but remains unbalanced. Growth has picked up, but long-term prospects are not that bright. Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.’
As always happens in times of ‘euphoric markets’…warnings go unheeded. And sure enough, US markets gave the BIS the old two finger salute overnight by hitting, yet again, another record high.
How high can they go? How far can the elastic band stretch? Well, we’re well overdue for a decent correction and that could happen any day now. But at a rough guess, this ‘euphoria’ will keep going until interest rates in the US move back above their ‘natural rate’. What does that mean? Well, the ‘natural’ rate of interest is where interest rates would be if central banks weren’t interfering on a daily basis. It’s the price of credit that satisfies the desires of savers and borrowers.
Think of it as the ‘intrinsic value’ of credit.
The annoying thing about the ‘natural rate’ is that no one knows what it is. But it’s fair to say that when rates stay below the natural rate for a prolonged period of time, you get a boom. When they move above the natural rate, you get a bust.
Global QE has ensured that the cost of credit has been below the natural rate for years. That’s slowly starting to end. The danger comes when central bankers try to raise rates. My guess is that the build up of debt over the past few years, much of it for speculative and non-productive purposes, means the natural rate of interest is probably much lower than people think.
So in the same way that rising rates popped the US housing bubble in 2006, there’s a good chance the Fed will screw this one up too and move rates above the ‘natural rate’. And once again, the BIS will sit back and say, ‘I told you so’.