Australian Rate Hike: Looking at the Logic

In last week’s article, I highlighted that one of the key positive developments this month was the Reserve Bank of Australia (commonly referred to as the RBA) hiking interest rates by one quarter of a point to 3.25% on October 6th. With the release of its notes from the meeting Monday, the logic for the decision merits some reflection.

Australian interest rates were high by global standards even before the move. The RBA was raising interest rates into early 2008 but began swiftly to move rates lower in late 2008 as commodity prices collapsed globally but paused at 3.0% after their April 8th, 2009 meeting. Almost exactly a half year later, the RBA has begun the process of boosting rates while central banks around the world continue to use words like “for an extended period” when referring to the need for low rates in the future.

The timing of such a move was more of a surprise outside of Australia than it was inside. The Australian bond market had been reflecting that a rate hike was expected either this meeting or the next. Does Australia see something the rest of the world doesn’t? Or is the RBA somehow freer to act before most industrialized economies? This week’s Barron’s cover offers unsolicited advice to U.S. Federal Reserve Chairman, Ben Bernanke: “It’s time to raise rates, Ben.”

In fact, much of the logic for a rate hike was tied to the prospects for the global economy rather than Australia’s domestic economy. Its economy is rather small and quite open while its currency, the Australian dollar is a favorite of fx traders world wide. As a result, Australia is more often a taker of economic data than an influencer of one. External factors such as commodities prices and global growth play a large role in the dynamics of the Australian economy. True, Australian miners such as BHP Billiton (BHP) and Rio Tinto (RTP) can restrict the supply of raw materials but they have no control over global demand.

In assessing the global economy, the RBA cited four key issues:

· Thanks to credit growth China’s Q3 should be solid but slower than Q2

· Asia’s trade recovery paused in August but may be returning in September

· U.S. outlook is improving but data remains mixed

· Inventory cycle is fueling industrial activity but this may be temporary

Such an assessment is not exactly a call to action. The RBA seems to see the same thing the Fed, the ECB, and the Bank of England see but they come to a different conclusion. The motivation to raise rates really comes down to Australia’s proximity to China:

There is no more important customer of Australian exports than China. The above graph (and the latter two) comes from a speech made Monday by RBA Assistant Governor, Philip Lowe. The speech is similar in points and tone to the RBA meeting minutes but provides more color to the arguments for a rate hike.

The graph outlines the leading countries that are the destination of Australian exports. In just the last decade, China has gone from being the number four destination for Australian goods, consuming just 5% to over taking Japan for the number one spot with 22% of exports. In the last twelve months, as other economies have faltered, the line for China has tilted almost straight up. There may not be an economy that is more linked to China’s industrial prowess right now than Australia’s.

Mining investment is hitting an all time high in Australia. Australia has a rich history of mining cycles. The most spectacular boom/bust cycle was probably the Nickel Boom of 1969-70, a period that might make the Nasdaq market in 2000 look uneventful. Yet during that period nor during the early 1980s (as the Japanese industrial boom was just entering it final decade) mining investment never been as large a percent of Australian GDP as it is today, recently eclipsing the 4% level.

The combination of low rates (3% truly is low for Australia) and outsized investment in mining can quickly lead to a tight labor market Down Under and rising wage pressure. Keep in mind, Aussie unemployment has not hit 6% in this cycle and may not do so. It is wage pressure, rather than commodities price pressure that central bankers fear when it comes to spiraling inflation. This is particularly true in a country that does not look to the outside for most of its raw materials. Most of what Australia imports are manufactured goods like computers and other electronics. There is little pricing power globally in this area.

Whether it is for use or for stockpiling, Chinese purchasing of raw materials is the critical variable in Australia’s domestic inflation equation. In addition to the volume of purchases, the price is still quite good.

Australian terms of trade have not been so good since the Korean War. Australia won’t be importing inflation any time soon. Even with the recent correction in global commodities, Australia’s terms of trade (a measure of pricing of its exports relative to that of its imports) are as high as they have been in more than a generation.

Australia shares some factors with other countries but terms of trade is not one of them. The terms of trade for Australia are actually quite unique. Exports are quite skewed towards raw materials such as iron ore and coal as well as food such as beef and grain. As investors, we should all be cautious of high prices though. As they say, high prices are the best cure for high prices.

Australia has a customer with a voracious appetite for its products, good pricing, and high levels of investment in bringing more products to market. What is not to like?

Apparently nothing … as long as it all stays this way. The tone of Mr. Lowe’s assessment of price stability for Australia’s products is almost one of disbelief.

A year or so ago, if one had known that global industrial production would decline by around 15 per cent, and that the world economy would experience its most severe recession since the 1930s, few would have predicted that global commodity prices would hold up at current levels.

Mr. Lowe goes on to point out there is no shortage of supply, citing a one third increase in iron ore exports in the past years as evidence that investment in the mining sector is paying dividends. As long as there is increasing capital trying to capitalize on the strength of the mining sector, it’s prudent for the RBA to keep the market from getting too hot and sparking inflation.

Regardless of whether the strength of the prices Australia sees is logical or not, the RBA seems to be saying, “As long as China is buying and the rest of the world is no longer collapsing, we need to be vigilant in our inflation concerns, despite deflationary fears elsewhere.” Let’s just hope China keeps buying.

Disclosure: No positions

Comments

[MikeOz:]

In addition to the factors you mentioned as reasons for the rate increase, the Australian Government (which had zero net debt one year ago) engaged in some fairly large (deficit) stimulus spending in the first half of this year (eg substantial cash handouts to nearly anyone) - on the basis that they wanted to pre-empt a recession.

Given that most Australians have barely noticed any economic downturn over the past 2 years (as you say - because of Chinese purchases of commodities), history will probably record that the Government over-reacted with the stimulus spending.
My guess is that was also a factor in the RBA's decision - though they wouldn't want to say it out loud.

Oct 21 09:17 AM

[tripleblack:]

Good insights on the topic. The take on the Australian stimulus may well be spot on.

Oct 21 09:54 AM

[ff4444:]

Good article. In my view if commodities, precious metals, etc. start appreciating against a currency then it is time to raise rates period. The whole discussion of "is it politically acceptable to impact the economy right now" is really beside the point and can never be settled satisfactorily.

Oct 21 01:24 PM

[Nicholas Ca...:]

Bryan, I enjoyed reading this.
I have a question about your last blog entry:
"It is clear that the Bank of Canada sees the strong ‘loonie’ as a threat to the Canadian economy. The only question is whether they will follow the lead of the Swiss National Bank and intervene to weaken their currency."

Seeing that Australia and Canada are similar in that both countries are commodity producers and have geographic networks to export, does a long Aussie Dollar short Canadian Dollar make sense if Canada is considering monetizing its debt (as you mention, following the Swiss' lead)? RBA raising rates strengthens this argument, correct?

(My goal is to reduce my USD exposure)

...I'm also drafting an article on this trade for my own blog.
reasonablythinking.com

Oct 24 03:33 PM