The Australian dollar’s rise following yesterday’s interest rate cut was unexpected. The dollar rose from by almost $1.50 to a recent high of $79.46.
The Daily Reckoning Editor Greg Canavan wrote yesterday morning, ‘the recent strength in the dollar is a concern [for the RBA]. The RBA may want to cut now to help knock it back down’. The RBA has tried, and so far it has failed.
What tends to happen when a central bank cuts rates is that the value of a currency drops. That was a big factor behind the RBA’s decision to lower rates in the first place. It makes it cheaper for banks to lend, and for borrowers to borrow. In effect it stimulates the economy as everyone, from businesses to consumers, spends more.
So an increase of credit leads to more money — causing inflation and lowering the value of the dollar. So why did it go up instead of down?
How US interest rates affect the RBA’s decision making
The RBA may have shed some light on this in its official statement. They mentioned that the US Federal Reserve Board may raise interest rates this year.
A US interest rate rise would strengthen the US dollar. At the official rate of 1.7%, the US Federal Reserve has lots of room to hike rates.
Any US rate rise would automatically relieve pressure off the Aussie dollar. This is because much of the world’s trade is conducted using US dollars, and its position as the reserve currency has a knock on effect to all other currencies.
Just why the RBA decided to mention this is anyone’s guess. The actual data coming from the US doesn’t indicate that rates will be lifted this year. The US trade deficit reached its highest level in over six years. That kind of evidence only suggests that rates in the US will hold steady.
Economists have tipped that the US Fed is likely to start lifting rates in late 2016. So it’s odd that the RBA is predicting a rate rise for this year. Whatever their reason for mentioning this, it may have backfired.
Why investors cooled on the share market
Another curious movement in the market yesterday was the lack of movement on the stock market following the RBA’s decision.
With Telstra [ASX:TLS] and ANZ [ASX:ANZ] among the companies enjoying early morning gains, overall trading on the ASX 200 and All Ords finished on par. The ASX closed at 5,826, which was roughly where it started. The lack of activity in the stock market might concern the RBA.
A rate cut typically results in cheaper access to money. Investors respond to that by flexing their new purchasing power in assets like equities. The only thing that explains their reluctance might be that they believe that rates will only go up from here.
If that’s the case, then it’s not what the RBA hoped would happen. Investors who believe this are more likely to keep cash assets. And that’s not going to help achieve the RBA’s aim of lowering the value of the dollar. The market is telling the RBA that it’ll need to do more to convince them that rates will remain at present levels. We can expect that they’ll try again next month if the dollar doesn’t depreciate soon.
Contributor, The Daily Reckoning
PS: The Daily Reckoning’s Greg Canavan says that we’re heading for a recession in 2015. He’s written a free report showing you why it’s inevitable, and how you can safeguard your wealth from it. In it, you’ll learn:
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