The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Sunday, April 3, 2011

The question of the curious AUD-rates nexus...

A trader in London remarked to me a week or so ago that the Aussie/US dollar cross was rallying hard--past 1.02--due, he thought, to interest rate differentials between the two countries, and expectations that the RBA was going to hawk up. His key point was that the AUD rally meant that, in turn, interest rate markets, such as the Australian 3 year bond futures, should sell off to reflect this dynamic. Or, put another way, interest rate securities had rallied way too far on the back of the offshore turmoil and were due for a downward correction (implying higher yields).

My response was a little more nuanced. First, I argued that the robust appreciation in the AUD actually had a much more important first-order impact on interest rate probabilities--to the extent that it was seen to be a permanent increase, it actually reduced the likelihood of future rate hikes. I made the point to him that the RBA had been surprised (pleasantly) by the very powerful pass-through effects of the AUD increase in 2010 on core inflation, which it had not anticipated, and helped explain recently low CPI prints.

Critically, the RBA was likely to be a little less dismissive of currency movements if these elasticities held going forward, which is a significant open question in and of itself. The point is that one can construct an argument that bond futures should rise, not fall, on the basis of currency appreciation, which contorts the conventional logic.

The second observation was that this is really all about causality: is the AUD rising because of perceptions of a stronger domestic economic outlook; or is it because of views on the weakness of the US economy's prospects? There is a compelling case that the latter has been driving the currency, especially given concerns around the impact of recent oil price shocks on US consumption and perhaps the insidiously-mounting-momentum around some type of QE3 by the Federal Reserve, which could hold US yields down longer than expected. While QE3 might be a tad improbable, the Fed might commit to avoiding a contraction in its balance-sheet as its massive holdings of US fixed income assets naturally mature, which would be a form of 'quantitative easing' (jargon for governments buying their own debt by printing money) in and of itself.

Looking through all of the noise, my own view is that, medium term, US bond yields are rising for a wide range of reasons, and the interest rate differentials between the two nations will therefore compress (due to the higher rate of increase in US yields from what is a very low base). This is likely to drive a medium term depreciation in the AUD at just the time core inflation pressures are building. A not insignificant risk to this view is any deterioration in the USD as the global reserve currency (likely in the longer-term in my opinion), and the desire of foreign central banks to diversify their huge holdings of US assets. Aussie dollars would be one candidate diversifier.

I note here that Joe Stiglitz was arguing in the FT the other day that more should be made of the IMF's special drawing rights (SDR) currency as a surrogate for a global reserve, which was a point I hade made myself when chatting with one very, very large investor a couple of weeks ago. (I also touched on Keynes's idea of a global Bancor currency.)

Moving on from my 3.30am LA time ramblings, HSBC's Paul Bloxham had some very nice insights on this subject in his latest note (the distinction between the AUD/USD and the TWI is key, which is something that Nick Gruen complained about the other day, and adds a great deal more complexity to my analysis above!):

"Most model estimates suggest that a 5% appreciation in the TWI takes around 0.2ppt off inflation and 0.1ppt off GDP growth in the medium term. In a similar way, most model estimates tend to suggest that a 25bp RBA hike takes around 0.1ppt off GDP and inflation. Thus as a crude rule of thumb, if the exchange rate is persistently 5% higher on a TWI basis, one less move by the RBA may be needed. Forward markets expectations of a broadly stable exchange rate around USD parity are our current technical forecasting assumption. Note that our FX strategists believe that the current strength of the AUD will prove transitory. Nevertheless, RBA officials may put greater weight on recent strength and believe it to persist, which could influence the policy-setting. Clearly the effect of the exchange rate on the economy depends on the reason for its change. But the current story seems to be mostly USD weakness, rather than Aussie dollar strength, which is exactly the kind of scenario that can be disinflationary."