Today’s Daily Reckoning has a simple task: to figure out what all this business in America means for Australia. Okay, it’s simple in theory, but maybe not so simple in fact. Let’s have a crack anyway.
The last few days we spent a great deal of time trying to discover the goal of the Fed’s $1 trillion foray into Treasury bonds and the U.S. mortgage-backed securities market. Why? Well, the Fed is trying to bring down ten-year U.S. interest rates. Why?
Yields on Ten-Year U.S. Notes over the Last Ten Days
If it can do that (and you can see from the chart above that it CAN), it brings down all sorts of interest rates that are pegged to the ten-year rate (like 30-year mortgage). If it can jigger mortgage rates down by buying ten-year bonds, it allows Americans to refinance for thirty years at around 4%. And what does that do? We’ll tell you!
It frees up household cash-flow. If American homeowners can lighten their monthly mortgage payment (and if oil prices don’t spike again causing pain at the pump) then Americans will have more money to spend (if they don’t lose their jobs)! And if Americans have more money to spend, they will buy the things made in China. And if they buy things made in China, it means China will need more raw materials from Australia.
Do you see where this is going? Under this scenario, a recovery in the demand for Aussie resources depends on the reflation of the American consumption bubble. This is exactly the scenario Stephen Roche warned about the other day during his Melbourne visit. Roche has been warning for years about the imbalances created by a global growth model that relies on credit-financed consumption.
But it looks like the Fed is trying to revive the old way of doing things…because that’s all it knows how to do.
The other main reason we’ve spent so much time investigating the American credit market is simple: if credit is hard to come by in America, it’s going to get even harder to come by in Australia. The Australian government’s effort to provide lending to “viable” commercial real estate projects (Ruddbank) will have to be expanded to include an even broader cross-section of the credit consuming economy. Why?
Well, Australia imports capital. The Big Four borrowed abroad to provide the funds to power the Aussie housing boom. You’re going to have a hard time having another housing boom if Aussie banks are jealous of their capital and unable or unwilling to borrow abroad. The Aussie housing market, then, is directly dependent on the success of the Fed’s efforts at un-freezing private capital in America. We know that’s not exactly popular among housing bulls in Australia. But there it is all the same.
There are other questions with a lot more difficult answers. For example, it’s already clear that the Fed’s big splash into the bond market is leading to higher commodity prices. Gold futures were up nearly 8% in New York as the old yellow metal closed near $960. Oil crossed over $50.
Those aren’t huge moves, mind you. They’re not small. But if we’re right, bigger ones will come later. And as we’ve said, you can’t expand the money supply like that without triggering inflation.
But will Australia import America’s inflation? That’s the key question of course. The Fed and the Reserve Bank must be confident that with the economy so slow, it will be some time (if ever) before the big expansion in money supply translate into higher prices. The Fed itself said it wasn’t worried about inflation.
We wouldn’t be so sure. If the Reserve Bank or the Rudd Government have to step in, Fed-style, and provide credit to the private sector or support the local bond market in the same fashion, it’s going to mean more money printing. As we’ve said before, there’s never been a case before where an increase in the money supply did not lead to inflation.
The alternative theory for Australia and America is the great deflation theory. That is, you still have trillions in losses from the financial system to work through. You still have massive over capacity in global production (demand far in excess of supply). And in Australia, you still have house prices that could fall 30% or more. In this scenario you get falling prices and asset deflation, not inflation.
Which scenario is going to win out? We’ll see…
And what about the stock market? Well, for base metals and bulk commodities producers, where prices for the underlying commodity are more correlated to economic growth, you would imagine it’s going to be pretty tough sledding. Demand will remain low and credit could be a problem for firms without cash saved up.
For oil, energy, and precious metals producers (and some explorers) we expect the situation to be a bit different. Kris Sayce has been making high with his LNG stocks at the Australian Small Cap Investigator. But to be honest, the moves in gold and oil so far haven’t confirmed the inflationary hypothesis. Why not?
With oil, there are other factors at play (inventories, lower demand, production cuts at OPEC, and in the long term, a lack of supply from under investment). For punters who are comfortable with being in the market right now, we’re still tipping oil shares in Diggers and Drillers.
With gold? Well, it’s obvious now that Ben Bernanke, Barack Obama, the American Congress, Kevin Rudd, Wayne Swan, Gordon Brown, Mervyn King, and the entire global elite are both terrified and utterly clueless. The only real plays in the monetarist play book are to print money and spend it. If that doesn’t cause inflation this year, we don’t know what will.
for The Daily Reckoning Australia