Will The Reserve Bank Of Australia's Rate Cut Revive The Australian Economy?

Includes: EWA, FXA
by: Ralph Shell

It is not that the Australian economy is suffering from a debilitating recession, as are some of the countries in Southern Europe, but the vitality of the economy has slowed. The Reserve Bank of Australia (RBA) yesterday reduced the bank rate .25 basis points to 2.5%, and down from 4.75% in August if 2011.

RBA Governor Stevens had these comments:

"In Australia, the economy has been growing a bit below trend over the past year. This is expected to continue in the near term as the economy adjusts to lower levels of mining investment. The unemployment rate has edged higher. Recent data confirm that inflation has been consistent with the medium-term target. With growth in labor costs moderating, this is expected to remain the case over the next one to two years, even with the effects of the recent depreciation of the exchange rate. "

The commodity boom in Australia, clearly, has peaked. Last week the RBA Commodity Index showed export commodity prices were down 11.8% from last year. Slower global growth, by the Chinese specifically, and the dampening of investments by the foolish mining "super tax" was not helpful.

Economic news remains lackluster. Earlier this week retail sales, expected to be up 0.4%, was unchanged. Tomorrow we get Australian unemployment news. It is expected that the rate will up to 5.8% from 5.7% last month. The AU Labor Force Participation Rate is expected to remain unchanged at 65.3%.

So what is the problem here? Compared to many European economies, and the US economy, the AU situation is far from dire. Malcolm Maiden, writing in The Age Business Day, says the RBA Governor may be troubled by excess free reserves in banks. He says:

One of the things the Reserve Bank has been trying to do with its cash rate cuts is persuade people to move money out of bank deposits into areas where it will generate more economic activity ...

Bank deposits totaled $974.9 billion in July 2007, just as the global crisis was unfurling. By July 2011, they were 55 per cent higher, at $1510 billion, as shell-shocked investors sought shelter from the crisis and the banks sought to increase deposit funding and cut back on short and medium-term debt funding that had been destabilized by the crisis.

By July 2012 the amount socked away in bank deposits had risen to $1,682 billion, and by June this year it was 6 per cent higher again, at $1,783 billion.

This means bank deposits from July 2007 to June 2013 grew by about 83% to more than the country's GDP. Is it possible during these turbulent economic times that Australia was the destination for those seeking both higher yields and safety? Awash with liquidity, banks were unable to find sufficient demand for their funds, and they likewise invested in the higher yielding AU paper.

The market for the Australian dollar has been under pressure because of the rate reductions. From a high of over 1.05 to under .89, the currency has had a sharp break. If there were unhedged speculators playing the carry trade or those looking for safe havens, the sell off has been brutal.

At the CME futures and option trade, the participation in the Australian dollar is quite large. Yesterday the total futures open interest was 200K contracts, bigger than the OI in the Japanese yen, 173K contracts. Further the last COT Report of futures and options showed the specs short a record 95.1K contracts. The bear market in the Australian dollar is no secret.

A 25 basis point rate cut does not usually instigate additional business activity, but is it right to anticipate additional cuts? Global interest rates, however, might be on the cusp of working higher. Today US equities sold off on talk of the Fed's possible reduction in the size of bonds purchases but debt markets were steady.

In Australia, despite the lower bank rate reduction, yields were 10 to 12 bps higher. Does this mean that the RBA is finished reducing rates? Maybe, but there are many possible scenarios, often outside of the RBA's influence.

For the currency, it looks to us that the market is overloaded on the short side. If the market conquers the .90 handle a retest of the .93 level is possible. As always, watch your money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.