This week featured two interesting speeches by Australian officials. On October 30, Philip Lowe, Deputy Governor for the Reserve Bank of Australia (RBA), gave a speech at the Commonwealth Bank Australasian Fixed Income Conference Dinner auspiciously titled "Australia and the World." Two days later, Wayne Swan, Australia's Deputy Prime Minister and Treasurer, delivered an speech titled "The Global Outlook, Fiscal Policy, and Two Versions of the Future" at the 2012 Economic and Social Outlook Conference in Melbourne, Australia. Both speeches contained what I think are further signals that Australia will remain biased towards lowering interest rates as long as the recovery in global economies remains anemic and/or uncertain.
Lowe described the two key international economic developments that impact the Australian economy: robust growth in emerging economies, especially within its Asian trading partners; and the on-going debt pressures in most developed economies. Growth in emerging economies underwrites Australia's growth while weakness in developed economies compels yield-hungry investors in those economies to invest in Australia. The result is a seemingly contradictory mix of upward pressure on the Australian dollar (FXA) and downward pressure on interest rates. According to Lowe:
…quantitative easing and weak growth in the large industrialised economies is likely to lead, for a time at least, to upward pressure on other currencies and lower interest rates around the world.
The bias of flows away from economies with quantitative easing and into economies with stronger growth is a dynamic that Ben Bernanke, Chairman of the Federal Reserve, has in the past refuted by pointing to the strong net capital flows into U.S. Treasurys (TLT) from other countries. Foreign governments own about 46% of all U.S. government debt. Foreign share of ownership of Australian sovereign debt has risen to about 83.5%.
On a relative basis, Australia experiences much stronger foreign influx of capital into its bond market. Lowe points to record low yields on Australian government bonds and falling credit spreads paid by banks as evidence of the strong capital flows into Australia. Moreover, "..these portfolio flows help explain why the exchange rate has changed little since mid year despite a general softening of the global outlook and a decline in key export prices."
Lowe provides this compelling depiction of the dynamics at work:
When institutions look for alternatives to holding large deposits earning a near zero return, they look not just at domestic assets, but at foreign assets as well. Not surprisingly, with the rest of the world doing better than the troubled advanced economies, many of the assets earning positive risk-adjusted returns are located outside the countries undertaking quantitative easing.
As a result of this, there is an incipient outflow of capital from these countries, and by extension downward pressure on their currencies.
Lowe goes on to explain that the resulting "…contractionary effects of an appreciation can be countered with more stimulatory domestic policy-setting - including through lower interest rates - than would otherwise have been the case." Lowe is justifying lowering rates by pointing to the need to relieve the upward pressure on the Australian dollar, pressure that would otherwise work to slow down Australia's economy if not checked. This statement is one of the clearest examples I have seen that the RBA is targeting a lower Australian dollar by reducing interest rates.
Swan's speech provides even more clarity on the government's belief that plenty of room remains to the downside for interest rates in Australia (emphasis mine):
Maintaining a strong economy and sound fiscal policy has seen increased appetite to invest in Australia. Where we were once seen as an optional investment destination, Australia is now seen as a necessary part of any portfolio, whether it be private or public investors - and these investment flows have propped up our sustained high dollar. This, combined with our fiscal consolidation and contained inflation, has all meant that our economy has more room to run lower rates than we have in the past.
I translate having "more room" to mean that the RBA is perfectly justified in continuing to lower rates under the current conditions, especially with investment flows keeping the Australian dollar too high.
Interestingly, low rates may not be encouraging more borrowing by Australian households. Instead, it seems low rates are allowing these households to pay off mortgages faster. Lowe clearly thinks this counter-productive given the goal of encouraging economic growth, and he states "these trends will obviously need close monitoring over the period ahead." The RBA will need to monitor this because this dynamic mutes the transmission accommodative monetary policy in the economy.
Australians are also monitoring developments regarding the fiscal cliff in the U.S. Swan spends considerable time talking about its potential impact on Australia and the global economy. He references the dire predictions of our own Congressional Budget Office (CBO) to highlight the point:
The independent Congressional Budget Office estimates the fiscal cliff, left unattended, could see the US economy suffer a crushing annualised contraction of 2.9 per cent in the first half of next year. The CBO also estimates that without action to avert the fiscal cliff, the unemployment rate would shoot up to more than 9 per cent by the end of 2013 meaning almost 2 million fewer jobs in the US than would have otherwise existed. That's the same number as the total number of jobs added in the US over the past year. A reversal of job growth such as this would have enormous human and economic costs. This would not only drive the US economy back into recession, but would strike a savage blow to the recovery in the global economy.
Whereas the European sovereign debt crisis took center stage for much of this year as a key economic risk for Australia, it seems the country is now pivoting to face the U.S.'s potential debt crisis.
Through all of these economic events and dynamics, the Australian dollar hangs in the balance. Against the U.S. dollar, the Australian dollar appears to have stabilized a bit, but it is still weaker than it was when the U.S. Federal Reserve announced a third round of quantitative easing in mid-September.
The Australian dollar has seemingly stabilized since selling off post-QE3
Since late 2010, the Australian dollar has traded within a wide band against the U.S. dollar.
The Australian dollar has traded in a wide band for two years and counting
Source for charts: FreeStockCharts.com
I am guessing that the Australian dollar's ability to retain a relatively high value despite several steep sell-offs over this period has provided positive reinforcement for the relative attractiveness of the currency. If the RBA wants to take its currency down to some lower trading window, it will likely need to get very aggressive with rate cuts. Currently, financial markets seem to expect this to unfold over the coming months. However, if inflation numbers keep printing hotter than expected like last month's CPI, this strategy may undergo significant dilution.
Be careful out there!
Additional disclosure: In forex, I am net short the Australian dollar.