The market is finally listening for every little cue from Glenn Stevens, the Governor of the Reserve Bank of Australia (RBA), and he is taking full advantage of it to help grease the skids for the Australian dollar (FXA).
On July 30th (Australian time), Stevens spoke at The Anika Foundation Luncheon using a speech titled "Economic Policy after the Booms." Overall, the speech was an important one in providing a broad perspective on the Australian economy and its prospects. I want to focus here on the key components related to the Australian dollar.
Firstly, Stevens made it clear that interest rates are likely to stay low in Australia for quite some time. He forecasts that "a stronger trend in non-resources business investment looks like it is a while off yet." This is important because such investment will be key in making up for the coming significant decline in the resource sector:
"Resource sector investment rose from an average of about 2 per cent of GDP, where it had spent most of the previous 50 years, to peak at about 8 per cent. That big rise is now over, and a fall is in prospect, with uncertain timing. It could be quite a big fall in due course."
Combined with lower consumption rates in Australia, this all adds up to low interest rates for the foreseeable future:
"…all other things equal, interest rates are likely to be lower in such a world than they were in a world in which households were extending their finances. This is a global phenomenon, but it holds in Australia too. A higher desired rate of saving ex ante means that the return to saving will, other things equal, be at a lower level as the market clears…In other words, with many investors wanting safety, the price of safety has risen."
Stevens justifies the low rates further by referencing the global phenomena of risk aversion even as asset prices, in this case natural resources, have soared:
"The fact that the rest of the world has had such low interest rates, that the desire for safe assets has been so strong, that the spreads between the cash rate and the rates that matter most for the economy have widened, and that people have sought to get to a position of lower leverage - all these have been important in explaining why the cash rate has been so low compared with what we had been used to until the mid 2000s. That this has occurred while we have had the peak of the resources investment boom is all the more remarkable."
These contradicting forces have intrigued me as well. I have interpreted it as evidence of dueling forces in the global economy between deflationists and inflationists acting at the same time. The deflationists are clearly winning overall because almost no one fears inflation but almost everyone still fears deflation and acts accordingly. It is what helps explain the willingness of bond markets to play to the tune of accomodative central bank policies. Meanwhile, investors/traders/consumers in places like China have behaved in inflationary ways by driving up property prices to extremely high levels and consuming vast quantities of natural resources, accelerating such consumption when prices move in their favor.
Lower rates also imply a lower Australian dollar, especially given the currency has been so high for so long in the post-recovery period. Stevens notes that the on-going decline is appropriate since a rebalancing of the Australian economy must involve more foreign demand (a trade surplus) that extends beyond commodities (emphasis mine):
"…successful 'rotation' of demand will probably also involve more net foreign demand for other Australian output of various kinds. Given that, the recent decline in the exchange rate seems to make sense from a macroeconomic perspective. It would not be a major surprise if a further decline occurred over time, though of course events elsewhere in the world will also have a bearing on that particular price."
"Elsewhere in the world" central banks have maintained exceptionally low interest rates that have made the Australian dollar more attractive than is desirable for Stevens and the RBA. However, the sharp decline in the Australian dollar seems to indicate that this favoritism has come and/or is coming to an abrupt end.
"…policies in major economies have been at very unusual, or extreme, settings for some time is a complication because of the potential effects on the exchange rate - though, as noted, the exchange rate appears to have been behaving more normally of late."
This speech effectively knocked the Australian dollar down a peg. The slide actually began with very poor building approval numbers for June, 2013. "Dwelling unit" approvals fell a seasonally adjusted 6.9% from May to June and 13.0% year-over-year. This was far worse than expectations for a 2% increase month-over-month and a flat year-over-year reading.(click to enlarge)
The Australian dollar had stabilized over the last month, but this relatively quiet period is likely about to end(click to enlarge)
Intraday view of the Australian dollar's latest takedownSource: FreeStockCharts.com
As I have mentioned in previous posts, I prefer fading the Australian dollar on rallies. I used the latest swoon to unload most of my short AUD/USD position. My approach has worked particularly well over the last month's trading range. However, the strategy will change if the Australian dollar finally breaks down again as I suspect it will soon. At that point, I will be shorting into weakness until some new level of stabilization occurs. Note also that Stevens's speech has quickly disabused me of the notion that I can/should use GBP/AUD to hedge much of my position long GBP/USD. I opened a very small short position on GBP/AUD just to test the waters and will likely close it out quickly (this week).
Be careful out there!
Additional disclosure: In forex, I am net short the Australian dollar and net long the British pound