Reserve Bank’s First Interest Rate Cut in Seven Years

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If you witnessed complete strangers linking arms and breaking into song in the street this morning, it was either a long-lost chorus line or a collection of relieved homeowners. Yesterday the Reserve Bank cut base interest rates for the first time in seven years. If you’re an average Australian, you’re now $44 better off each month. Or $528 each year.

What of all that hoo-ha about Big Banks keeping the cut to themselves? It turned out to be just that. A monumental load of hoo-ha. Within nine minutes of the RBA’s announcement, all four had passed on the savings. Pretty eager. Who said there wasn’t enough competition in the banking sector?

Don’t think the credit ‘crunch’ is over though. This is the downleg of a cycle, not a blip in a glorious, perpetual uptrend as some people seem to think. Kris Sayce at Money Morning spies a dissenter in the market. Wizard Home Loans didn’t lower interest rates. It raised them. Check out today’s MM for the full story, and all your other important market news.

Meanwhile, the economy is blowing a cloud of fog into investor’s windshields.

The first thick layer of mist becomes apparent in Glenn Stevens’ official statement. Here are the two paragraphs to take note of:

The rise in Australia’s terms of trade that has occurred is working in the opposite direction [to slowing growth], adding substantially to national income and ability to spend. Fixed investment spending by businesses continues to be very strong. At the same time, high prices of oil and a range of other commodities have added to global inflationary risks. They are also dampening growth in a number of countries.

Given the opposing forces at work, considerable uncertainty has surrounded the outlook for demand and inflation. On balance, however, it is looking more likely that household demand will remain subdued and overall economic growth slow over the period ahead. Inflation is likely to remain relatively high in the short term, with the CPI affected by the high global oil prices in mid year and other increases in raw materials prices.

In plain English, there are opposing forces. The rising Australian terms of trade is bringing money into the economy, fueling it. A higher oil price is adding helium to the price balloon too.

Meanwhile, the credit crunch has smashed investments and caused money markets to flare up. The upshot: higher market interest rates, lower asset values and less spending by John Citizen. Poor Johnny C.

That’s pulling the economy down.

We have consumer price inflation plus a stagnant economy. Stagflation. The two-headed ogre of despair. With its dual maws, it attacks wealth from two directions at once. Rising prices mean Johnny C pays more. A slower economy means he has less wealth to spend in the first place.

Central banks are only equipped with one sword: manipulating cash rates. ‘Sword’ might be a generous term. Maybe butter-knife is better. Anyway, it can’t take out both the ogre’s heads at the same time whether it’s slashing or buttering. So what’s the economic solution?

There isn’t one. Not based on Keynesian, business cycle-smoothing economic policy. Or any other economics for that matter. An economy is a self-correcting system. It’s correcting the low prices and high growth we’ve had for years…with high prices and low growth.

So there’s that first layer of mist. Economists are faced with a scenario they’re not used to. Economic ‘uncertainty’, as Glenn Stevens put it. Hence the fog. How do you invest when the future is invisible?

(If you answered the housing market, go sit in the corner. If you can even afford the rent of sitting in the corner. Investing in unaffordable assets is not advisable. And we see Money Morning has a nice graph of what unaffordable housing looks like today too.)

We’ll get to a real investing solution shortly.

First, we spy a second layer of wisping, foggy uncertainty. A cheaper Aussie dollar. The interest rate cut has slashed over US13c of value from our little gold kangaroos. They’re trading at US83.5 cents today.

Other currencies are giving our dollar the hop too. That’ll only serve to import higher prices from overseas. Australians paying more for things, in other words. The left head of the ogre just grew a little. Which problem should the RBA deal with? Slower growth or higher prices?

Again, this isn’t the kind of thing a central bank is equipped to deal with. An article in The Age down here in Melbourne hinted we might see the RBA switch back to raising rates. Just to keep the dollar up. That’s getting fancy. A cut here, a snip there. A deft dodge, a subtle weave. Now we have a ballet dancer taking on a two-headed ogre with a butter-knife. Eeep.

It’s an absurd suggestion. But it’s evidence that this is a serious dilemma. Absurd suggestions start appearing when there are few good ones. We have rising prices from higher incomes…higher prices from a lower currency…and slower economic growth from high market interest rates. It doesn’t bode well for individuals or businesses.

About that solution. Quickly.

It’s no barnstorming, revolutionary idea. It’s just picking an industry that has the best of this world.

Raw materials companies are Australia’s breadwinner. Undeniably. The RBA’s still worried about ballooning prices. Mainly because mining exporters are still pulling in cash from Asia. Those rising terms of trade are concentrated in a few industries; coal, iron ore, energy, wheat. If the Australian economy is a water balloon that expands and contracts, there’s only one thin straw drawing real, liquid wealth inside. That straw is Western Australia, Queensland, and their natural resource advantage.

It’s the precursor to the inflation that keeps the RBA up at night. Mining earnings. Inflation’s first stop-over in Australia is BHP’s income statement. Unlike John C Citizen, and most other businesses, miners are still making money. Most coal companies locked in double digit earnings growth last month with contracts.

The lower Aussie dollar doesn’t hurt every industry either. China’s basically pegged to the US dollar. As far as Beijing is concerned, Australian coal is US13 cents cheaper than it used to be. So are the coal companies themselves.

And those falling asset values? That’s the key. That’s what makes investing in resource firms timely. Without a broken stockmarket, miners might still be trading at P/Es double those of today. Buy low.

So Diggers and Drillers will be stocking up on miners this month and next. More than usual.

Al Robinson
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Hi Al,

    I would like to question your talking down of the property market in particular the Australian property market. (I do not own any property). Are you bearish about the Australian property market also? You did not really specify which countries property market you were referring to. Clearly the Australian economy is coupled to the price of resources (ie. coal, gold iron, etc) so if resources increase in price the Australian economy will surge and thus people will have more money to spend on housing. So stronger commodities = higher Australian real estate values.

    If anyone can spot a flaw in my reasoning please let me know. Or maybe it is a mistake to apply reason to markets in the first place!

    Thanks

    Dave

    Dave In Elwood
    September 5, 2008
    Reply

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