RBA Cuts Interest Rate to 5.25%

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Well how about that. No one knows who the new U.S. President is yet and the U.S. dollar is already weaker. The dollar fell 2.6% against the euro overnight. But all the real action was in the commodities markets-the same ones that are off around 50% (or more) from their highs this year. Gold was up by six percent to $757 and oil rallied ten percent to get back north of $70.

Before we forget, we put out a feeler last week to see if anyone wanted to get together in Melbourne for holiday drinks on December 9th. Let us know at dr@dailyreckoning.com.au. It will be somewhere down on Southbank. And if we’re lucky, we think we might even be able to snag Bill Bonner and Michael Masterson to visit again this year. It’s nothing formal. Just some friends ringing in the end of the year.

Now to the markets. Aussie stocks should have a nice tailwind for the rest of the week. The flip-side of the weaker greenback is the appeal of over-sold commodities. And besides, a relief rally is a relief rally. The Dow cruised up 300 points and the S&P 500 climbed just over four percent to get back over 1,000.

And then there’s the rate cut. In case you missed it, the RBA cut the cash rate by three quarters of a percentage point. It’s now at 5.25%. But did you notice a hint of indecision in the comments the Bank published with the decision?

The bank is contending with slower growth AND inflation. But it needed to cut rates. So it had to minimize the threat of inflation…even while acknowledging it. First came the case for lower rates. “Recent reductions in borrowing rates,” the RBA said, “the depreciation of the exchange rate and the fiscal stimulus announced in October will work to assist growth in the period ahead, but deteriorating international conditions and falling commodity prices will have a dampening influence.”

Yes. It’s all falling apparent. Global manufacturing. Global consumption. That’s all pretty damp.

Yet inflation remains persistently and annoyingly high. “Consumer price inflation in Australia remained high in the September quarter. As expected, CPI inflation in year-ended terms picked up to 5 per cent, while underlying measures were just over 4½ per cent.” Hmm.

In the end, the Bank concluded that, “it is reasonable to expect that inflation in Australia will soon start to fall. Global disinflationary forces will assist in this regard.” Fingers crossed. Despite the rate cut, the Aussie dollar soared against the USD overnight.

So when you get a rising Aussie dollar and rising commodity prices, does it mean global equity markets are pricing in inflation and hedging with tangible assets? Probably not yet. Commodities are surely oversold. But you’re also starting to read a lot of stories about a hard-landing in China.

These stories can’t do much to help commodity prices. On the other hand, the weakness in commodity prices has kicked off what Diggers and Drillers editor Al Robinson calls the “Pebbles” phenomenon. Larger commodity producers or even end users are taking advantage of weak share prices in the juniors to acquire bigger stakes.

The West Australian reports that Mt. Gibson Iron ore (ASX:MGX) is entertaining an offer from China’s Shougang Concord and China’s APAC Resources which would see those firms raise their equity stakes in MGX to 40.5% AND secure discounted ore for the life of the mine. Now that is a deal you could only make from a position of strength.

Are these Chinese firms white knights or red dragons? Does it really make a difference? We’re back to the same question of who benefits the most from the long-term demand for the ore. The Chinese steel producers have the chance of a lifetime to secure off-take from Australian mines at bottom-of-the-barrel prices. But what does it mean for current or future shareholders in the juniors?

Here’s what Al says, “In short, the steel sector will huddle together for warmth over the next six months. We’re going to see demand for steel and steel-making ingredients move down slowly. Then the recovery will come from developing countries later in 2009.”

“But right now, the balance of power has definitely shifted. You’ll see more of these iron-steel project equity agreements in late 2008 and early 2009. It’s a way for both parties to get some security. It’s a way to wring some risk out of the contracts. And it’s yet another step towards where we see the iron industry inevitably heading: Chinese firms owning a lot more of Australia’s iron mines.”

“Shareholders in the juniors will be in for volatility. It still isn’t clear in the long run who will control the Pilbara. But right now Australian iron ore shares are factoring in a global depression. The buyers are completely ignoring the growth in the developing world that’ll come in the next decade. Better yet, our favourite iron play is still sitting on the sidelines – making cash every quarter regardless of who owns the mines.”

Oops. Sorry for the typo yesterday. We accidentally wrote, “Who is going to American a trillion dollars? The Chinese? The Japanese? The Gulf States?” The missing word was “lend.” Who is going to lend America a trillion dollars?

But perhaps the question was geopolitically naive. Maybe you shouldn’t think of this as ‘lending money to America’. Maybe you should think of it as geopolitical ‘protection’ money. As one reader wrote in, the lenders will be, “Any sovereign that wishes to stay in the ‘protection’ racket. I reckon that out of the possible three choices, the Japanese and the Arabs are prime candidates.”

What about the Chinese? They aren’t stupid. They understand the American consumer is no longer a reliable customer. He’s bust. He’s not buying houses. He’s not buying cars. He may not even buy toys for his children this Christmas. Scrooge.

If China can’t generate export surpluses to the U.S., it won’t have sizable dollar-denominated cash flows to recycle back in to Treasuries or U.S. stocks. You get the end of positive feedback loop/vendor financing scheme that’s driven global growth since 2003.

This again argues for higher U.S. interest rates, if you take the Chinese out of the market for U.S. Treasuries. Besides, the Chinese aren’t exactly in thrall to the U.S. for military protection from external threats. In fact, some trade protectionism from the next U.S. Congress and Administration could precede more military tension between China and the U.S. over Taiwan. The less each country thinks it has to gain from doing business with the other, the more likely they are to lock horns.

Not that it’s smooth sailing for the Chinese economically. If the U.S. stops buying what China’s making, then the Chinese economy stops growing as quickly. This is economically and politically destabilising, which is just what the communists in Beijing want to avoid. Perhaps that’s why they are scrambling, like everyone else, to stimulate domestic demand.

Round and round we go until we arrive at a point of irony for globalisation. The more connected things are, the more fragile they become. Generally it doesn’t work that way when you’re building physical structures. More connections contribute stability and strength. But networks are more complex.

The idea that globalisation and free flowing capital benefit everyone equally is, well, absurd. It’s generally good for everyone, in that the world’s productive capacity increases and prices for finished goods come down. But we’ve also seen how the increase in productive capacity means that countries with higher wages (U.S. and Europe) haemorrhage high-wage jobs.

The global poor get slowly richer. But the middle class of the English-speaking economies, well, they might expect to lower standards of living, on average. That’s certainly not something governments want citizens to know. If they DID know, they might want to opt out of it.

But just how do you secede from the new world order these days anyway? Maybe we’ll find out. IN the meantime, we predict a complexity catastrophe. Attempts by national governments to insulate and protect local economies from the great world depression will backfire and end in recriminations, unintended consequences, and maybe some bullets flying over borders.

When things are so interconnected, everyone’s affected by everything, whether they like it or not. And as Eric Beinhocker writes in The Origin of Wealth, “The probability that a positive change in one part of the network will lead to a cascade resulting in a negative change somewhere else grows exponentially with the number of nodes. This in turn means that densely connected networks become less adaptable as they grow.”

Isn’t that what we have? The global financial system is becoming increasingly less adaptable the more governments get involved. That slows it down, makes it unresponsive, or responsible in unpredictable, often undesirable ways.

Dan Denning
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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