Australian Dollar: The Return of the Pacific Peso

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If the world’s currencies are in a street fight, the Australian dollar just got punched in the face. And then kicked when it was down.

In overnight trade, the Aussie fell more than one cent against the greenback, which is a massive decline in the world of foreign exchange. It’s now below 78 cents. The Pacific Peso is back!

The US dollar bull market just doesn’t want to take a break. The Aussie wasn’t the only currency to take a beating. While the euro managed to stay on its feet and even land a cheeky jab on the greenback, the smaller players all copped a kicking.

The precious metals weren’t spared either. Gold fell nearly US$30 an ounce while silver was almost hospitalised with an 6% decline.

Reuters, scrambling to explain the big fall in the precious metals, put it down to some sort of delayed response to the Federal Reserve’s statement released 24 hours earlier.

The reasoning is much more simple. That is, decent US data overnight suggests the Fed is still on a tightening path, which provided another excuse for the US dollar to rally and anything ‘non-dollar’ to fall.

And don’t forget, precious metals have had a good run over the past month…some profit-taking and consolidation should not come as a surprise. Taking a bigger picture view, there’s an increasing probability that the long bear market in gold could be coming to an end.

In yesterday’s monthly issue of Sound Money. Sound Investments, I showed, through charting analysis and with some help from my mate, Quant Trader Jason McIntosh, that gold could be beginning a new bull market.

According to Jason, the charts are starting to look promising, with the gold price recently breaking up through levels of resistance. After such a strong run you should expect some sort of correction and indeed you’re seeing that now.

The big question is how far the correction runs. That will go a long way towards supporting or refuting the claim that gold is in the early stages of a new bull market.

But for Aussie investors it’s a different story. Thanks to the weakness in the Aussie dollar, the gold price in Aussie dollar terms is very strong. Despite the fall overnight, AUD gold is around $1,620, which is up from around $1,480 at the start of the year.

That’s not a bad move and shows that gold protects your purchasing power when a fiat currency is under pressure.

Why is the Aussie dollar a bit of a punching bag right now though? There are plenty of reasons. Collapsing iron ore and oil prices (which will hurt future LNG exports), pathetic politicians devoid of any leadership qualities, worries over China’s economy…just to name a few.

But more immediately, it seems the market is moving ahead of the RBA’s decision on interest rates next week. Ever since Canada threw in a ‘surprise’ rate cut a few weeks ago on the back of the sharp fall in the oil price, the market has zeroed in on the RBA’s meeting next week.

There’s a widespread view that Glenn Stevens will cut the official rate for the first time in about 18 months when the RBA meets on Tuesday. I’m not sure exactly why this view is now so prevalent. After all, it wasn’t long ago that the consensus thought higher rates were likely in 2015.

I’m taking the other side of the interest rate cut trade. Let me tell you why…

It’s not because I’m bullish on the Australian economy. Over the next few years, you’re likely to experience the worst economic conditions Australia has seen in decades. This scenario has been in the pipeline for years.

But it’s going to be a slow melt at first. Right now, there is no real compelling evidence to cut rates. This last paragraph from the RBA’s December board meeting tells you our heroic central bank is pretty calm about the national cost of credit right now:

In the Board’s judgement, monetary policy is appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target. On present indications, the most prudent course is likely to be a period of stability in interest rates.

A period of stability tells you the RBA isn’t panicking. Yes, commodity prices have fallen considerably but so has the Aussie dollar. The lower oil price offers consumers a bit of a tax cut through lower petrol prices, which is a positive.

And don’t forget the lower dollar acts as stimulus for the economy. In addition, it increases the price of imports, which leads to inflationary price pressures assuming these rising prices are passed onto the consumer.

All these reasons argue against an immediate rate cut. And the economic news hasn’t been too bad lately. Importantly, the labour market remains resilient.

The other point to note is that the RBA moved very quickly to cut rates sharply once falling commodity prices started to affect the terms of trade in 2011. The rate cutting cycle that started in October 2011 and finished in August 2013 took a massive 225 basis points off the official cash rate.

That was a significant amount of stimulus and created a house price boom and a big (and welcome) pick up in housing construction.

Most of that stimulus has now started to wear off though. This is why the calls for interest rate cuts are getting louder. But Glenn Stevens knows that monetary policy has it limits. He’s said so publicly in an attempt to get the government to take their budget problems more seriously.

What happens after the RBA cuts again? We’ll just be in the same situation in another 12 months…asking for more monetary stimulus. So my bet is that Stevens will want to keep his ever dwindling stock of interest rate powder dry for when the economy really needs it…and it will later in the year.

But first, you should expect to see a tweak in the all-important language used by our venerable central bank. Expect to see that change on Tuesday. The phrase, ‘a period of stability’ will probably go.

I should point out though that the market says I’m wrong. Stocks have put in a big rally recently, lead by the banks on the hope of more interest rate stimulus. It doesn’t pay to argue against the market, but this time it appears to be getting a little ahead of itself.

If the RBA doesn’t deliver the monetary sugar next week, expect the Aussie to rally and the market to sell off…at least in the short term.

Regards,

Greg Canavan+
for The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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Kate
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What happens to the Aussie dollar against the U.S. if rate cuts do (or don’t) go ahead? Is it wiser to pay a large U.S. sum now rather than hang on for the next 6 months or is it likely the dollar will continue to fall?

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