You always need to think about both sides of the trade in financial markets.
So it was with interest that I read Adam Carr’s recent Business Spectator article titled ‘The RBA must raise rates for a lower dollar’.
I haven’t seen this said anywhere else. The conventional thinking says lower rates equal a weaker currency and vice versa.
It’s widely believed the interest rate differential between Australia and the rest of the ZIRP West is the reason our dollar is still strong. That means any increase in our cash rate would likely strengthen the Australian dollar further and hurt our exporters.
Questioning this wisdom is good and healthy. It makes you think.
Adam begins his article boldly:‘Yes, it’s true. If the Reserve Bank of Australia wants a lower currency, then the smartest thing it could do — right now — is hike rates.’
I’m hooked. The smartest thing to do is hike rates. Anyone with no debt and money in the bank would be very eager for the Reserve Bank of Australia to adopt Adam’s suggestion. The higher the rates the better I say.
Adam is of the opinion the RBA should take a leaf out of the New Zealand central bank’s playbook and get in front of the soon-to-be rising global interest rate curve: ‘To see this, take a look at New Zealand’s experience. The Reserve Bank of New Zealand has hiked rates four times in four months — a full percentage point to 3.5 per cent — and the currency has done little.’
It has taken a 3.8% tumble lately due to a sharp fall in dairy prices AND the NZ central bank warning it may intervene to push the currency down (at US 88 cents the Reserve Bank of NZ considered the NZD too strong).
In a yield hungry world, the attraction of a 10-year government bond paying 4.23% from a AAA rated country is quite evident. Hence the rush from institutions to throw money into the coffers of our neighbours across the ditch.
That’s unless the world abandons its policy of interest rate suppression and rates start to move higher in the US, Europe, UK and Japan.
It’s this belief that underpins Adam’s ‘higher interest rate, lower dollar’ strategy (emphasis mine):
‘Either way, policymakers have a choice: Global rates are going up, this we know, and the RBA can either choose to lead that cycle or they can lag it. I would argue that regardless of what the unemployment rate does leading the cycle will confer on Australia considerable tactical advantages if it’s serious about the currency over the long term.’
The facts are at odds with his assertion that ‘global rates are going up, this we know…’
Two months ago, European Central Bank President Mario Draghi announced a reduction in the official cash rate from 0.25% to 0.15% AND lowered the overnight bank deposit rate (for funds held with the ECB) to negative 0.1%.
And in the US, despite the Fed continuing with its taper program, bonds yields have fallen in 2014. Perhaps Adam’s position is an assumption interest rates will ‘normalise’ in the not too distant future. Certainly, the prevailing economic thinking is that the Fed will start to raise rates — perhaps in 2015. But relying on the Fed to do what they say is a leap of faith.
Back in December 2012, then Fed Chairman Bernanke said short term interest rates would most likely rise if US unemployment reached 6.5% or lower. The latest US unemployment rate is 6.2%. Rates are still stuck at 0.25%. Why? Because the Fed knows that there are less people looking for work and this artificially lowers the unemployment number. The average US consumer is struggling with falling real wages and rising living costs. The squeeze is on in middle America.
The less than upbeat economic news out of Europe — Italy back in recession; a slump in German factory orders; Portugal bailing out Banco Espirito Santo — is not going to have Draghi turning the interest rate dial up anytime soon.
In my opinion, interest rates rising anytime soon is far from a sure bet.
Making any forecast on the direction of interest rates and share and property markets is based on an assumption that the world continues on the slow, torturous path to recovery — the one we’ve been on for the past five years.
But as they say ‘there’s many a slip twixt the cup and lip.’
The highly respected Indian Central Banker, Raghuram Rajan, warned on 7 August 2014 about the unintended consequences of ZIRP.
He sees increasing global financial instability due to investors being forced to chase higher returns (the historically low interest rates being paid on junk bonds supports Rajan’s concern).
According to AAP (emphasis mine):‘India’s central bank governor, renowned for forecasting the 2008 financial meltdown, has warned that the world economy faces risk of another market crash as asset prices surge.’
What happens if Rajan is on the money again and we have GFC MkII? This would change a whole lot of assumptions.
Should this eventuate (personally, I say chances are better than 60%), the RBA are likely to follow the overseas lead and plunge our cash rate below 1%.
The Aussie dollar would be cast aside like a dirty rag as institutions rush to the perceived safety of US Treasuries. The exodus would cause the Aussie to head south at a great rate of knots — probably into the 50 cent zone or possibly lower (it touched 48 cents in 2001).
Prepare yourself for GFC MkII to be more severe than the GFC. The central bankers have nothing left in the locker to fight the next major financial crisis.
The unrestrained markets forces, free from the Fed’s intervention, twill then wreak the greatest possible havoc.
The Fed’s post-GFC ‘efforts’ to save the world have delayed the date of execution. Compared to 2008, today there is more debt in the system, AND optimism in risk assets is at an all-time high because investors believe the Fed has their backs.
The Fed has created a world of make-believe. A world where printing money leads to economic prosperity and the almighty central banker can control markets.
All dreams end when you wake up to reality. Raghuram Rajan is warning our destined meeting with reality is a distinct possibility.
But getting back to Adam Carr’s interest rate theory…
While I’m all in favour of the RBA raising rates to benefit the savers of Australia, I don’t think higher rates will help lower the Australian dollar.
In my opinion, the direction of interest rates and the dollar are likely to be taken out of the hands of the RBA. The very real prospect of GFC MkII means our central bank will be left pulling the only lever it has left — lower interest rates.
The combination of a shrinking interest differential between us and the rest of the world and a ‘flight to safety’ mentality is going to drop the Aussie dollar into the cellar.
A lower dollar is in our future, and it’s likely to come via lower rates being forced upon us in a period of extraordinary economic upheaval.
This last statement is also not conventional thinking.
For Markets and Money