A Melbourne Cup Day Bonfire of the Currencies

All Australian eyes may be on the Mufti these days, but we're also keeping our eyes on the currency markets. Why?

Two reasons, the prospect of new riots in France next week and the riot of words coming out of Alan Greenspan's mouth yesterday. Both could contribute to a stronger Australian dollar and pressure on the Reserve Bank to raise rates by more than a modest 25 basis points next week on Melbourne Cup Day.

"We're beginning to see some move from the dollar to the euro, both from the private sector ... but also from monetary authorities and central banks," Greenspan said yesterday at a conference. This, coupled with the news of the largest decline in median American house prices in forty years, took the starch out of the American dollar and saw it fall against most major currencies, including the Australian dollar.

Greenspan again drew attention to the American trade deficit, saying, "We'll get to the point at some point that willingness to finance it will slow, and if you can't finance it, it won't happen."

What is the "it" that won't happen? The dollar retaining its value? Its status as world reserve currency? What?

We weren't able to find an elaboration on the Chairman's comments through the Google. But it doesn't matter that much anyway. Further loss of faith in the greenback and dovishness from the U.S. Fed (because of America's weak housing market, which has been holding up the economy) means a stronger Aussie dollar.

What’s more, we’ve been keeping our eye on the U.S. dollar index in Outstanding Investments. Its failure to break above 87, and its recent retreat lower, is both dollar bearish and commodity bullish. See the chart below.

With this kind of action going on around it, frankly, the Aussie dollar doesn't need much help from the RBA. The economy is growing. Exports are booming. As a commodity currency, the Aussie dollar is already attractive.

Under these circumstances, the Reserve Bank doesn't have to raise rates to strengthen the currency. It might want to do the opposite, in fact. If the dollar gets too strong it will hurt the profit margins (if not the competitiveness) of Aussie exporters. But the dollar may get even stronger in the coming weeks, against the euro, for example. Why?

Next week France celebrates the one-year anniversary of last year's bonfire-of-the-Puegots-and-Renaults. Early commemoration ceremonies this year have included the forced evacuation and later torching of three passenger busses in suburban Paris.

While there is no direct link between busses burning in the streets and the strength of a euro as a currency, social mayhem in one of Europe's biggest economies can't exactly be good for the long-term strength of the euro, or the health of la France.

If the Aussie dollar finds itself rising against the American dollar and the euro, the Reserve Bank will find it difficult to raise rates, further strengthening the local currency. But it may have to just that if signs of inflation keep popping in the economy, or at least convince the market it has not fallen behind the inflation curve. Yesterday's 5.6% pay rise for minimum wage workers by the Australian Far Pay Commission puts even more pressure on the RBA’s new governor Glenn Stevens to establish his bonafides as an inflation fighter.

Unless you’re a currency trader, none of this is immediately actionable. But it will be interesting to watch and see what affects these currency and interest rate moves have on the stock market. Will the market reward currencies backed by soaring trade surpluses and real commodity reserves? Will it punish the currencies of chronic debtor nations?

History shows us that most poorly managed currencies eventually go up in smoke, not worth the paper they’re printed on. And when that happens in America, as it eventually must, it’ll be more than currencies and than busses that go up in smoke. It will be pension funds, life savings, maybe the stock market, and Alan Greenspan’s reputation.

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found