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Tuesday, October 4, 2011

Self-correcting markets: delivering stimulus to Australia without RBA/Treasury doing anything (charts)

One of the things that investors and economists struggle with is “dynamics”. George Soros prefers to term it “reflexivity”. In the econo-jargon they have an even fancier sounding term: “endogeneity”. A bricky might sum it up simply as "the knock-on effect”.

Bluntly stated, events have consequences, and to have the best possible chance of working out the future, you need to spend a lot of time thinking hard about them. A good example is the current public or “sovereign” debt crisis. All of this started off with a credit crisis amongst private borrowers. The consensus solution was to bail-out the private sector with public money because we wanted to avoid the risks of a 1930s style depression.

Setting aside the long-term moral hazard implications of “socialising” private mistakes (ie, the “heads I win, tails taxpayers lose” dynamic), an unanticipated knock-on effect of the policy reactions to the 2007-09 calamity has been the 2010-11 public debt crisis and, more particularly, the possible disintegration, or at least restructuring, of the Euro-zone and its once-successful common currency.

Another knock-on effect that I'd like to discuss today has been the stunning appreciation of the Aussie dollar during 2010-11. Many economists and investors believed that due to the enormous local investment in resources, Australia would eventually run-in to an inflation problem with the consequence being higher interest rates. We did indeed see a rebound in core inflation, and the RBA has dutifully lifted rates to above-average levels. But what most people, including the RBA, did not originally count-on was that the Aussie dollar would soar to more than 110 US cents.

According to the RBA’s research, every 10% increase in the currency reduces core consumer prices by about one percent over the following three years, with most of the impact coming in the first 12 months. We had a peak-to-trough 36% increase in the Australian dollar spot (as measured against the US dollar) since its low of about 81 US cents in 2010. Taking a more reasonable trading range, the rise has been more like 15%.

The key point is that the unexpectedly strong advance of the currency was a crucial “deflationary” impulse that helped the RBA to keep rates on hold following its first contractionary hike in November 2010. The central bank has recognised this by referring to the role of the currency with mounting regularity as a restraining influence on inflation and activity over 2011.

Coupled with a rolling series of crises that nobody predicted, from the east coast floods, to the Japanese tsunami-cum-nuclear catastrophe, to the oil price shocks induced by the Middle Eastern revolutions, domestic hikes that were slated to materialise gradually disappeared (my own views have not changed).

Now the economy’s restraining knock-on effects are actually working in reverse. Just when every second bank in the country was upwardly revising their forecasts for the Aussie dollar to around 110 US cents or higher, the currency has fallen like a stone on the back of risk-aversion arising from the snowballing European woes.

As I write, it is trading at just 95.28 US cents, and looks like it may break through to 94 US cents. That is a 16% fall from its peak, and a 10% plus decline from its average in 2011 (see chart).

So, while a raft of banks have swung 180 degrees to adjust their interest rate forecasts from hikes to cuts in 2011-12, including, amongst others, Goldman Sachs, Deutsche Bank, Westpac, Macquarie and AMP, the “shock absorber” that is Australia’s currency is delivering de facto rate cuts as we speak.

Recall the chorus of calls in the media from countless vested interests that the high Aussie dollar was killing industry? You don’t need to have a plus-size cranium to work out why such whining has suddenly stopped.

The 10-15% fall in the Aussie dollar significantly improves the competitive position of exporters (including those that sit on the RBA’s Board) as the price of their goods and services is lower (assuming our trade-weighted exchange rate moves by a similar margin). It also assists import-competing industries, such as manufacturers, given that the price of imports increases (thus making their goods and services relatively cheaper).

A permanent decline in the exchange rate of this magnitude is also quite explicitly inflationary, as research published by the RBA only a couple of weeks ago shows.

A final knock-on effect I want to discuss today concerns interest rates. As most know, the RBA is responsible for setting the level of interest rates across the economy via changes to its "official target cash rate". In this context, one of the many good things the RBA does is provide detailed information on the "average" interest rates (eg, deposit and home loan rates) that prevail across the market.

I have been writing for quite a while now about how the "inversion of the yield curve" has driven down the cost of fixed-rate loans. This is basically econo-speak for telling you that the financial markets believe that the price of money in the future will be lower than it is today (ie, future interest rates will be less than current-day rates). The markets believe this because they think the RBA will be forced to cut its cash rate on the back of lower-than-expected global growth. A related nuance, which I have explained in detail before, is that the price of fixed-rate Aussie government bonds has exploded due to the latter’s appeal in a world of deteriorating sovereign credit quality.

On Monday Australia's largest mortgage broker, AFG, reported a "huge spike" from 9% to 16% in the share of people using fixed-rate loans. Now, according to the official RBA data, we can say with certainty that the average 3 year, fixed-rate home loan has fallen by 0.70 percentage points in recent months, or by nearly three full RBA rate cuts, which would amount to 0.75% (see chart).

Indeed, 3 year fixed-rate home loans have not been this cheap since way back in July 2009 (ie, more than two years ago). The RBA has lifted interest rates on seven occasions since that time. In fact, the cost of 3 year fixed-rate home loans actually peaked at 7.8% in April last year. Today's rates are now 1.1 percentage points lower than those levels (the equivalent of more than four RBA rate cuts).

A similar thing has happened with small business loans (see chart above). According to the RBA's data, the 3-year fixed rate for small businesses has fallen from 8.75% in April 2011 to 7.80% today, or by almost a full percentage point (ie, four RBA cuts).

In summary, the markets and the economy have responded to quickly deliver the stimulus many doves argue that Australia desperately needs—in the form of a much lower currency and substantially reduced interest rates—without the policymakers at the RBA or Treasury having to lift a finger. This is one illustration of why markets can play a very valuable, self-correcting role. It is also another reason why the RBA will likely keep their finger off the rate trigger until the global dust settles.