2011 saw a dramatic change in how the Australian market reacted to a crisis overseas. This is nowhere more evident than in the reaction of the Australian dollar (AUD) says Roger Bridges, Head of Fixed Income at Tyndall AM.
Historically, any hint of a crisis or funding problem saw the AUD fall due to our vulnerability to overseas funding, as well as the AUD being seen as a commodity currency and therefore world growth-dependent.
However, recently the traditional link between a financial crisis and a fall in the AUD appears broken because Australia retains a solid AAA rating and this particular crisis revolves around sovereign rating downgrades. Despite concerns about world growth, the AUD has held around parity, although any concern over China does seem to raise this old link again.
The strength in the AUD in 2011 had a lot to do with the US economy as the AUD tends to go down as the US dollar goes up. A weak US economy, with extremely low interest rates and accommodative monetary policy to help increase liquidity in US markets, helped fan inflation in other countries, particularly Asia, in 2011. However, the high AUD not only prevented it affecting us but in fact was deflationary, helping to lower inflation back into the RBA’s target band.
The fact that inflation was deemed to be lower than previously thought allowed the RBA to cut rates and seemingly endorsed the overly aggressive number of rate cuts that the bond market has been predicting for some time.
The role that the AUD plays in relation to the economy will be key for 2012:
- The strong AUD, plus the rise of Australian consumer buying on the internet, has lowered barriers to trade in the Australian economy. This is causing disruptions to the retail and tourism sectors, although it must be a positive for capital importers e.g. mining. As a result, the Retail Trade monthly series is generally painting a weaker picture on the consumer pulse than the more inclusive National Accounts quarterly number.
- We would argue that this doesn’t necessarily mean a downturn. It merely reflects the changing nature of consumer spending. The internet may account for some of the decline in clothing and department store spending, but it appears that what the Australian consumer is buying is also changing, with money flowing into services rather than goods. We’re eating out more, buying more food, but spending less at Myer’s or David Jones–a trend that is likely to continue in 2012.
- Even though it has been painted as an insurance cut based on Europe, the fact that the AUD seemed to lower Core Inflation is what allowed the RBA to cut rates to 4.25%. In fact, I am beginning to hypothesise that the cuts are largely attributable to the AUD helping to control inflation–without it, the RBA would probably not have been able to do so.
- The issue is that with the lack of spare capacity and low productivity, can we afford to keep cutting based on the strong AUD keeping inflation low? In effect, the RBA would be starting to import the loose liquidity conditions of the US.
- Likewise, if the domestic economy comes off or China rolls over would the relative strength of the AUD hold up? Doubtful. This could then become inflationary.
- The bond market is currently predicting interest rates at 3.1% by October 2012–is that likely? I think 3.1% still looks too aggressive, although this has been true since July 2011. We could easily see a cut to 4.00% in early 2012, but further cuts will depend on the world outlook and its effect on the AUD and domestic inflation.
- Early 2012 seems calmer than the second half of 2011–Data in the US is looking hopeful with a recent drop in unemployment as just one of the positives. Chinese growth continues to slow but that is what policymakers had intended and they have some way to go before the economy is in any real trouble. In addition, China’s demand for commodities remains high with copper imports hitting record levels in December. This commodities demand is likely to continue in 2012 and should benefit our economy.
- Concerns about the Euro breaking up are far too pessimistic – sorting out their problems will be a long and painful process, but the French and Germans aren’t about to give up on their Euro project. Everyone has too much lose to let it disintegrate.
- But while uncertainty, fear and pessimism persist, the Australian government bond market is likely to continue to be expensive. With US Treasuries, UK gilts and German bunds offering record low yields due to flight to safety buying, the higher-yielding Australian market will continue to be attractive. Ironically, it is this very attractiveness that will raise prices and push those yields lower, further distorting the yield curve and indicating rate cuts far below what is likely or reasonable.