How US Inflation is Affecting the Australian Dollar

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It was a great week for market pricing. For a few days there the bond market vigilantes made a cameo appearance and set the rate of interest on ten-year US Treasury notes higher than the Federal Reserve’s target. Ben Bernanke and his gang of counterfeiters at the Fed like to think they are in charge of the nation’s money. And if by “in charge” they mean “reducing it to decorative scrap”, well, they are right.

But this week was a victory for market prices and a warning to the American government and the American consumer. The world is watching you! They know that your spending problem is out of control. And in this third and last great phase of global industrialisation, capital will find a much warmer welcome in places that are not the US bond market.

This means American interest rates will rise and the dead beat, loser politicians in Washington will run out of lenders for their ludicrous foreign military adventures and even more ludicrous domestic fantasies. In some ways, it will be a great day for America when the Chinese stop buying T-bonds.

But that day is not quite today. Treasury yields have risen for the sixth straight week. Old habits die hard, though. US bonds will surely attract some buyers as yields rise. The great rout we expect as the endgame for the US dollar may not happen as imminently as gold bugs would like.

Australian readers may wonder why we keep blabbing on about rising US interest rates and comparing them to the large intestine. After all, there is a central bank mismanaging the currency right here in Australia. And there is inflation here, too. Why not talk about yesterday’s speech by Glenn Stevens?

Okay, but only for a moment. In truth, what happens to the US dollar is a lot more important to the Aussie dollar than what Glenn Stevens says about inflation. For his part, Stevens told the market yesterday that inflation was a long-term worry but not a short-term worry. So traders who’d bet on an increase in the Aussie dollar exchange rate against the US dollar were disappointed and sold.

But against the yen, the Aussie dollar continues to roar ahead. And the difference in interest rates between Australia and Japan explains why. The yield-spread between 10-year Aussie and Japanese bonds is about 4.32% – its highest level in five years. For any trader with a half a brain, you borrow money in Japan and invest it in Australia.

The hidden partner in this yen carry trade is the US dollar. Japanese monetary policy is essentially a mirror of US policy, but with a few small differences. Japan must constantly keep its currency cheap against the US dollar so that Japanese exporters are competitive in the American market.

Practically speaking, this means when the Fed inflates, Japan must inflate just a little bit more. The Japanese don’t mind this so much since they are also fighting the dregs of deflation – that economic condition that results after a bubble burst and no one has the heart to believe in a bull market in anything. The Chinese must also create money when the Fed creates money. And in absorbing this money back into their own financial system, the Chinese have imported the Fed’s inflation. At last, an American import that does well in China. Inflation!

If it starts to sound absurd, well that’s because it is absurd. If everyone inflates when the Fed inflates, then there is a whole lot of inflating going around. Hence the rise in global money supply and the rise in asset prices. In other words, oh very patient dear reader, world financial markets are soaring because the US monetary authorities are crashing the dollar.

That’s why we focus so much on ten-year US notes. When the interest rate on the ten-year note rises above – and well beyond – the Fed’s target, it as clear a signal as you’re ever going to get that the world has told the American dollar to go stuff itself. So it’s worth watching for (sorry if we sound defensive when it comes to discussing bond yields. We know they can be boring. But the intestine is boring, too, while also a critical system in a healthy body).

Dan Denning
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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steven
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The U.S. has a trade deficit with Mexico as well. Yet, their central bank rate is at 7.25% and the peso hasn’t moved significantly against the US dollar in past 3 years. Why doesn’t Mexico feel the need to inflate a bit more with respect to U.S. like Japan does?

Trying to learn how this works. thx for any insight.

wpDiscuz
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