The Australian Dollar is Caught in a Currency Crossfire

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In today’s Daily Reckoning we’re going to discuss the possible impact on Australia of a changing global monetary system. We say possible because no one really knows where this rabbit hole we’re heading down leads, so it’s all guesswork.

But perhaps yesterday gave us a sniff of what’s to come. The Australian dollar soared early in the day, heading towards US97.5 cents, but then plunged nearly US1 cent in the afternoon. It fell further overnight, and currently trades around US96.2 cents.

Why the wild swings?

Well, early in the day inflation data came out much higher than expected for the September quarter. It showed price rises of 1.2%, well above expectations of a 0.8% quarterly increase. Despite the fact that this represented a faster than expected decline in the purchasing power of the dollar, traders rushed to buy on the expectation that there would be no more interest rate cuts for some time.

Higher nominal interest rates relative to the rest of the world are bullish for a currency, so the Australian dollar soared on the news.

But then in the afternoon the old Chinese jitters came back into the market. Signs of tighter money market rates in China, along with a surging yen, spooked investors and the dollar plunged. At least that the story from the FX markets.

But it was probably something far simpler. As in…the Aussie dollar had rallied about 8% in the space of less than two months, and it was time for a pullback. That’s right, it was only a few months ago that the Aussie had breached US90 cents on the downside.

This type of volatility is extraordinary, but it’s become far more ordinary in the modern day degenerate financial world we’re in.

We think part of the reason for the Australian dollar’s wild swings is because it’s a derivate of the most important exchange rate in the world, the US dollar/Chinese yuan rate. And China artificially maintains this rate in order to gain trade advantages over the rest of the world via a weaker currency.

If China didn’t manipulate the exchange rate, the yuan would rise against the US dollar and the trade flows between the two countries would be completely different. If that were the case, then China wouldn’t be printing so much of its own currency to maintain the artificial exchange rate. And if it didn’t do this, there wouldn’t be so much fuel for the current credit boom that’s going on over there.

Linking it back to Australia, if there wasn’t a credit boom in China there wouldn’t be an iron ore boom here…or as large a property boom for that matter. Many Chinese citizens are looking to parley their success from punting on higher house prices in China by punting on higher house prices here. It’s all fuel for the fire. 

International traders know the Australian dollar is a derivative of the USD/yuan phoney rate. They view Australia and the Aussie dollar as a proxy for what’s going on in China. So bad news in China means sell the Aussie dollar. For what it’s worth, we reckon there’s bad news coming up for China. Its property boom is again getting out of control, and China’s timid leadership will surely start to rein it in…again.

But the big question is, how long can China go on manipulating its exchange rate against the US dollar? The US continues to persist with very loose monetary policy, and via the currency peg China imports US monetary policy. The yuan has strengthened against the greenback a little over the past year – by around 2.6% – but not enough to stop the flow of excess liquidity into the Chinese economy.

As we discussed earlier this week, China is busy establishing bilateral swap lines with many of the world’s central banks so it can bypass the US dollar when conducting international trade. We don’t know what the ramifications of this will be once it’s set in motion, but you would have to expect it would strengthen the yuan against the greenback.

How would this impact on Australia’s economy?

Well, it would probably put an end to the Chinese credit bubble (which makes us wonder how slow China will be in actually instigating these bilateral trade routes) and transfer purchasing power to the Chinese household sector (via a stronger yuan relative to other global currencies). This would make foreign consumer goods cheaper and promote the long-awaited and much talked about rebalancing of the Chinese economy by promoting domestic demand.

Which is all good long term. But as we keep pointing out, such a rebalancing will see China’s economic growth fall sharply for at least a few quarters, and perhaps longer. This won’t be good for Australia and will put pressure on the Australian dollar.

But on the other side of the 20-cent piece, you have a much weaker greenback – assuming China stops trying to support it via the manipulated currency peg – which will provide support for the Aussie.

A sharply slowing China coupled with a higher Aussie dollar would be a double whammy and a nightmare outcome for Australia. It would crush our exports and the trade and current account deficit would widen considerably.

As the system degenerates, you’ll probably see both outcomes – a weak AND strong Aussie at different times. As a sign of this systemic degeneration, we think you’ll see global capital returning to the core, and the core of the system is US dollars. So a sharp rally in the US dollar just prior to its plunge against real tangible goods (i.e. major inflation) wouldn’t surprise us. Everything will move around wildly.

But nothing would surprise us over the next few years. We’re deep in the rabbit hole and no one really knows what’s going on. All you can really be certain of is that there will be a lot of volatility ahead…especially in the currency markets.

As for Australia, unfortunately we think there’s a high probability that China will run into problems with its Ponzi scheme very soon. As in by the end of the year. A lack of new credit of large enough magnitude to sustain the boom will trigger the problems, rather than a deliberate move to get out of the dollar.

From there is will be interesting to see China’s response in terms of maintaining its artificial peg to the dollar. Jim Rickards would say you’ll see a major escalation in the currency wars if economic growth in China slows markedly…it’s the only large economy in the world exhibiting decent growth.

As for Australia, we’re a mouse on a field of giants. The best we can do is try to keep out of the way. That will be difficult.  We’ll no doubt cop a few kicks as this game winds down.

Regards,

Greg Canavan+
for The Daily Reckoning Australia

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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5 Comments on "The Australian Dollar is Caught in a Currency Crossfire"

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slewie the pi-rat
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‘This type of volatility is extraordinary, but it’s become far more ordinary in the modern day degenerate financial world we’re in.’ once Kuroda donned the mission’s white scarf and climbed into the cockpit to fire up the BOJ Yen print-fest, the USD[X] seemed to get more volatile, too, as gold headed south for the Spring. now, this is becoming acculturated into the NWO Normal. {how’s THAT for Sociology? L0L!!!} is the new guy in India an IMF agent? aren’t they all working for the BIS, anyhow? {extra credit?} China has had many monetary hand-shakes, most recently with the EU, and… Read more »
Ross
Guest

Risk-on-risk-off trade is an instrument of war armed by smoke-for-collateral. Why wouldn’t you?

Remember now all that work from the protagonists poo-pooing the Chinese capital controls? An imperfect solution then for an imperfect world.

And now? An even more imperfect solution for a world with no growth outside of hyper stimulated China.

And the solution? Turn all those determined Chinese peasant savers into determined consumers that spend and borrow. Good luck with that to both the Politburo and the world’s US Feds.

Corporatism meets a stubborn and morally superior foe.

Garry
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“”” They view Australia and the Aussie dollar as a proxy for what’s going on in China “” Waffle, I say. The Aust$ is merely a proxy for the price of the rocks we dig. Rock sales decline, so does the Aust$. Yes there is a nexus to China, but only via the rocks they buy from Australia, given that rocks and food are the only items of interest they have here. Also there is a perception that if China is sick they will not need as many rocks, but more likely this will never be the case. Rather, the… Read more »
Dulong Ttil
Guest

I believe that what the Japanese government is doing to push the YEN down healthily is also an appropriate action for the Australian government to consider.

Since the YEN is much cheaper than before, the export and tourism businesses in Japan are much more active again.

Also, if the A$ depreciate, it will show an improvement of our overseas investments which are usually calculated in foreign currencies.

So, before A$ starts to depreciate, it should be a good idea for investors in Australia to rapidly purchase some overseas assets e.g. the supermarket in Hong Kong and businesses in China.

Jimmy
Guest

Garry, The FED is a privately owned bank, It’s not a part of the Government, there’s nothing federal about it. Under the Federal reserve act of 1913 (I believe), they can do whatever they want, a law unto themselves. There is plenty of proof of this on You Tube. Where did the half of trillion dollars go ??? I dunno, LOL.

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