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Tuesday, July 19, 2011

Twist your mind to imagine non-linearities like the Aussie dollar at 1.50 US cents....

When thinking about investing and life in general, I try to conceive of so-called ‘non-linearities’. These are situations where the world suddenly veers off our ‘central-case’, or most probable course.

This is why I find someone like Dr Steve Keen interesting. While Keen has arguably been wrong about a lot of the things he has sensationally forecast, he is effective at painting extreme pictures. Every so often, one of these unexpected events can materialise as our ‘central case’ amongst the millions of possible paths life can take.

The ‘Great Recession’, as it is known in the northern hemisphere, or ‘North Atlantic crisis’, as RBA officials incorrectly call it (recall they cut interest rates to 40 year lows while Aussie government debt exploded!), or the ‘GFC’ as it is uniquely referred to down under, is a graphic illustration of a non-linearity.

And, to Dr Keen’s credit (pun intended), he was right about the hazards that leverage can embed in a financial system.

With that cue, it is instructive to think through the possibility of the Aussie dollar advancing to levels much higher than most currently anticipate—say to $1.25 or $1.50 US cents.

This would have serious ramifications for Australia’s housing market. In particular, it would crush demand amongst foreign buyers while also cruelling income and growth in both the export industry, which would be rendered less competitive, and in businesses that compete against imports, which would be dramatically cheaper.

The one positive of a super high currency is that it could alleviate the need for future interest rate hikes, and even compel the RBA to cut rates.

As long-time readers will recall, my own central case has involved a global inflationary cycle as sovereign states seek to inflate their way out of public debt crises, which, it is too rarely noted, were originally private debt problems. Combined with the incredible surge in private investment to capitalise on the ‘Chindia’ induced commodity price boom, this explains why I have been an inflation ‘hawk’ (about 60% of Australian inflation is actually explained by global inflation).

Another key element of my central case has been a deterioration in the US Government's creditworthiness, and a rise in US yields to reflect (a) higher US inflation tolerated by authorities happy to see the fixed-value of US nominal debt decline, and (b) the higher probabilities of US government default.

Thus far this story has played out nicely, much to the frustration of folks like Paul Krugman, who would have us believe that US inflation is not, in fact, a credible concern. This does not sit comfortably with the latest data released on Friday, which showed core inflation in the US running at a 2.9% annualised pace over the past three months, which is way above the Fed’s target of less than 2%. (And so much for the pundits who canvassed ‘deflation’ in the US last year.)

Many respected economists are now openly talking about the merits of a bout of ‘surprise’ US inflation. The trouble is that this would not be a surprise to anyone, and would likely translate into higher long-term inflation expectations, which can then feed back into prices. The real risk is that the current public debt crisis undoes three decades of hard work by central banks to secure so-called ‘price stability’ (or low and relatively predictable inflation).

I have previously assumed that the rise in US government bond yields forces an appreciation of the US dollar since global exchange rates are ordinarily determined by interest rate differentials. This is a contingency that RBA Board member, Professor Warwick McKibbin, also believes is very possible.*

If the US currency rises, the Aussie dollar spot mechanically declines. This means we start importing more inflation on top of any domestically generated price pressures (especially since key trading partners like China have US dollar pegs). And higher inflation means higher interest rates.

One potential shortcoming in my story (and McKibbin’s scenario-analysis), which I have been seeking to highlight of late, is a non-linearity. This is probably best called the “Global War for the Preservation of Capital”.

More specifically, my base-case does not account for the relationship between a deterioration in the US government’s creditworthiness and the value of the US dollar as an international store of wealth. That is, the greenback’s historical role as the international ‘reserve currency’.

This non-linearity could produce a seemingly unexpected outcome: soaring US bond yields coupled with a static or declining (rather than rising) US exchange rate.

Another thread of logic that lends weight to this possibility is the fact that a depreciation in the US dollar improves the international competitiveness of US exports, and thus provides short-term assistance to its economic recovery and the political imperative of reducing the US’s 9.2% unemployment rate.

There is little doubt that much of the motive behind the US’s current program of ‘quantitative easing’ has been a deliberate attempt to put downward pressure on the greenback to help US exporters who have for years laboured to compete against the artificially depressed prices of Chinese products (given the value of the Chinese currency has been held down via its US dollar peg).

We are already seeing parts of this new story play out, which explains the otherwise bizarre behaviour of the Aussie dollar, which used to be a world growth/commodity proxy (and normally suffers badly during market ructions).

Today foreign governments, and their agents, central banks, are desperately diversifying out of the old ‘safe haven’ currencies (with the exception of the auspiciously austere Swiss) in recognition of an emerging new world order dominated by Asian economies. So they are selling the US dollar, the British sterling, and the Japanese Yen.

These historical stores of wealth are being destabilised by competitive currency devaluations (resulting from US, UK, and Japanese central banks doing almost anything to keep official interest rates ultra-low) in the name of inflating their way out of the twin evils of difficult-to-payback sovereign debts and post-GFC economic stagnation.

Investors are also beginning to realise that the present fiscal challenges are a veritable ‘pimple on the arse of an elephant’ when juxtaposed against the future pension crises that could be eventually triggered by the ageing of Western (and Japanese) populations.

In the race to preserve wealth in a world in which governments are either defaulting on their debts or debasing them through currency depreciations and inflation, the Australian and Swiss exchange rates stand out as two islands of economic, fiscal, social and political rectitude (despite what local partisans might have us believe).

In addition to having negligible net government debt, high interest rates (and hence attractive yields to holders of government bonds) and the providence of possessing an extraordinary bounty of natural resources that just happen to be in high demand (these points are actually related), Australia’s trade relationships, unlike the Swiss and, say, Canadians, are relatively insulated from the US and European woes.

In economic terms, we are a resolutely Asian nation, albeit with the legal and political stability of an Anglospherean Western democracy. Our four biggest trading partners are, after all, China, Japan, South Korea and India.

Sure, this is a globalised economy, with deep interdependencies. Yet Australia’s developing country partners, China and India, will almost certainly keep on urbanising and industrialising even with stasis in the US and Europe.

The shifting of the currency sands I have described above is confirmed by discussions with leading investment bankers, who report immense demand for Australian government bonds almost irrespective of their price.

That is, buyers don’t really care if Aussie bond prices fall in value a bit in the event that the RBA nudges rates higher to subdue inflation because they are earning strong and secure (from a credit perspective) underlying yields. And most of these buyers are foreign governments that will likely hold the bonds to maturity, and are therefore indifferent to fluctuations in price.

The demand for Aussie government debt has seen a tremendous increase in its price and thus a decline in its implied yield (the two are inversely related), which at around 4.3% today is well below the RBA’s target cash rate of 4.75% (see chart).

Normally this ‘price action’ would portend disaster for the local economy. The likes of Westpac’s Bill Evans evidently thinks so. Yet I would venture that it is perhaps more a reflection of the global war for the preservation of capital.

One constraint on the ability to obtain Aussie dollar exposures is that there is only a small stock of government debt--around $197 billion worth. This means that the currency could face unprecedented demand combined with limited supply, which could collectively conspire to propel its price to previously unimaginable highs.

The risk of this event is highlighted by the vastly asymmetric responses of the Aussie dollar to the 2010 and 2011 sovereign crises. Last year the Aussie battler plummeted from 93 US cents to 80 cents (see chart), which is what typically happens when financial markets are in turmoil. In contrast, the Aussie dollar has hardly budged during the graver 2011 episode.

There is a further nuance here that could make central bank purchases of Aussie dollars a smart trade. If the currency keeps on appreciating, the exchange rate could end up doing much of the inflation-fighting work for the RBA.

Crucially, this means that the holders of Aussie government bonds (more than 75% are foreign investors) would minimise any capital losses inflicted by an inflation-induced rise in market yields (which would reduce the price of their bonds) while benefiting from an increase in the capital value of those assets on their balance-sheets via the soaring Aussie dollar.

Forecasting is a difficult trade to ply given the complexities of the world in which we live. It is more useful to think of the future as a distribution of potential paths. For example, imagine the world as having a ‘base-case’ bookended by ‘upside’ and ‘downside’ scenarios. When trying to sketch the contours of any downside event, it pays to twist your mind to visualize non-linearities.

History has a tendency of surprising us by overshooting both good and bad expectations.

*A crucial assumption made in McKibbin’s analysis is that “the main financier of global public debt (namely China) to the major borrower (namely the United States) [does not lose] its appetite to continue lending on the same basis as before.” One objective of this article was to test that assumption.