A Rate Cut Weakening the Aussie Dollar Would be Counterproductive

Symbols of percent on falling red cubes.

Remember a few weeks ago when US stocks broke out to new all-time highs?

Now we know the reason.

On Friday, data released in the US showed the economy growing much slower than expected. Wall Street thought growth for the three months to 30 June would come in at an annualised rate of 2.6%.

Instead, actual growth was just 1.2%, while first quarter growth numbers were revised down to 0.8% from an initial estimate of 1.1%.

That makes it three consecutive quarters of sub-2% economic growth for the US economy. And the stock market breaks out to new all-time highs just ahead of this news. The market knew what was coming.

That is, growth is weak enough to keep the Fed on hold (and maybe even ease again), but not weak enough to send the economy into recession. Not yet, anyway.

That’s just the way the market likes it. Hence the break out to new all-time highs.

If you think this is crazy, you’re not alone. As the Financial Review reported on Friday:

Sharemarkets are at record highs, yet professional investors around the world are scared.

So scared that in July a record proportion of them put money into investments that hedged against the risk of a potential crash, according to Bank of America-Merrill Lynch’s latest fund manager survey. That sounds entirely reasonable – there’s a lot to be worried about, after all.

Yes, there is a lot to be worried about. But when isn’t there?

One thing you absolutely must learn about the market is that it isn’t there to satisfy your views on what should happen. It’s your job to make sense of it.

Even the professionals can’t make sense of it so, as the article above suggests, they’re insuring against a potential crash.

But do stock market crashes happen when everyone (or at least a lot of players) thinks one is inevitable?

No, they don’t. At the very least, it’s a low probability outcome. Betting on a low probability outcome is not usually a profitable exercise, unless you do so via the options market (for example), where the payoff for being right is huge, but the cost of being wrong is low.

And thinking about the market ‘mood’, the present seems very different to what it was like in late 2007, when we were on the precipice of a monumental crisis.

I remember that time clearly. I was on a flight to the Gold Coast to give a seminar. I was reading an essay by former Morgan Stanley Chief Economist, Stephen Roach. In it, he pointed out the huge and destabilising imbalances that were building in the global economy.

I had been worried about the market for some time, and said so in my presentation. I told people the market was overvalued and vulnerable, advising them to avoid the banks. I remember one lady coming up to me after saying she had pretty much all her money in ANZ.

My talk had her slightly concerned. But most attendees were after tips. Not many were really interested in a cautious or bearish message.

This was in November 2007 from memory. Hindsight told us that the market had already peaked. But there weren’t a bunch of nervous Nellies around back in late 2007. In fact, apart from a fringe bunch of analysts who thought things were about to go pear-shaped, most people thought the market would only head higher.

Today, the mood is very different. Despite being eight years ago, the 2008 credit crunch is very much on peoples’ minds. The fear of another 50–60–70% crash just won’t go away.

And while not impossible, I don’t think such an outcome is likely while there is continued angst about it. The market simply doesn’t act the way most people expect it to.

That’s why you’re better off going with the flow. Don’t fight the market. Try to understand and profit from it even when you don’t agree with it.

Despite the bad news on the pace of US economic expansion, the Dow Jones index only fell slightly, while the S&P 500 finished marginally higher on Friday.

The big mover was the US dollar index, which fell 1.31%. That reflects the likelihood that the next supposed Fed rate hike won’t happen anytime soon.

Dollar weakness is bullish for gold, and the yellow metal surged around US$20 an ounce in Friday’s trade. Is the gold correction and buying opportunity I’ve been talking about over?

I don’t know, of course. But what is clear is that investors ARE buying the dip in gold. Prices don’t have to fall too much before buying support comes in. That is certainly bullish from a longer term perspective.

And what does all this mean for Australia?

Well, with the Fed again on the back foot, it’s making our currency undesirably stronger. After Friday’s trading session, it’s back up to 76 US cents. That’s not something the RBA wants.

And given they meet tomorrow to decide on whether to lower interests rates again, the dollar’s strength could have important implications.

Having said that, cutting interest rates just to weaken the dollar would be a dumb and counterproductive move. The last few rate cuts have had no bearing on the dollar. China’s latest growth pulse is having a much greater effect on the value of our currency; all the RBA has to do is wait for that growth pulse to fade, as it inevitably will.

Rate cuts simply encourage a greater amount of debt accumulation, which pushes up house prices even further and increases the long term risks to financial stability.

Another rate cut tomorrow would be grossly irresponsible. Especially given we’re not even remotely in a global economic emergency situation. What happens when the proverbial really hits the fan? We’ll be in the trenches holding a gun without ammunition, watching the enemy come towards us in their thousands.

So my guess is that the RBA will hold off for at least another month. But who knows what they’re thinking? Central bankers and their economic models are cut from a different cloth from the man (or woman) on the street…who tend to get on with things armed only with common sense.

If only central bankers had more of that…


Greg Canavan,
For The Daily Reckoning

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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