Caution in the Wind

U.S. stock indexes began by posting strong gains yesterday as the Federal Reserve reiterated a commitment to keeping interest rates “exceptionally low” for “an extended period,” but investor fears caused a rapid retracement in the last hour of trading. The Fed announcement highlighted the slack remaining in the U.S. economy, saying that growth would be slow to return while capacity utilization ratios remained depressed. Inflation is expected to remain low until the economy approaches capacity again. Rising commercial real estate losses and increasing unemployment levels are weighing on economic prospects in the United States. Asian and European indexes extended the following slide into this morning as investors shifted to a more cautious outlook around the world.

The Bank of England expanded their quantitative easing asset purchase programme by 25 billion pounds, bringing the total to 200 billion. The Monetary Policy Committee held overnight lending rates at 0.5%. Both actions were widely expected, and Sterling slid slightly on the news. The European Central Bank meets today, and is also expected to keep rates on hold. The accompanying statement will be parsed carefully for indications that exit strategies are being considered, and EUR pairs should experience volatility as a result.

December gold futures rallied to just over $1094 USD an ounce, within striking range of the $1100 barrier. Oil futures traded below $80 a barrel as the Energy Information Agency released a report forecasting a drop in demand over the next year, but seemed to be on the way back above $80 as investors trade crude as a proxy for the USD. The yen rose against most currencies worldwide as safe haven buying drove demand.

Carry Trade Carries On, But for How Long?

On a trade-weighted basis, the USD dropped almost 1% over the trading cycle, and the Canadian dollar picked up a corresponding gain against it. The CAD remains largely range-bound, with the Bank of Canada’s recent comments making traders afraid to push it through 1.0550 towards par, but with support in the 1.0900 area provided by USD weakness. Markets are gradually transitioning towards an interest rate-driven dynamic, and central bank pronouncements on inflation and economic growth should continue to dominate the economic calendar for some time yet. Once interest rates begin to rise, the status quo will be upset, and currency markets will break out of their trading ranges.

A consensus is beginning to emerge that the “correlation trade,” wherein equities, fixed income assets, commodities, and the U.S. dollar all trade in sync, constitutes a bubble. New York University perma bear Nouriel Roubini has called it the “mother of all carry trades.” Several influential analysts, including the senior leadership at PIMCO, the world’s largest bond fund, have recently highlighted the risks associated with the Fed’s easy money policy, and are calling for an eventual pop. As we’ve seen in the last few weeks, the most likely trigger would be a perception that the recovery is derailing, and investors are watching economic releases very closely for signs that the real economy is faltering. This investor unease makes tomorrow’s U.S. Non-Farm Payroll report pivotal for many investors, and has made it the most important economic release on the calendar for some time now. Instability in investment perceptions and in the markets themselves is at very high levels, and a stampede for the exits driven by economic data is a clear risk – and a potential opportunity.

Ask Karl: Aussie Rules

This week, we turn to a nation that has a lot in common with Canada. Both countries are blessed with vast natural resources, are conveniently located close to their largest export markets, and enjoy sports that resemble unarmed combat more than civilized entertainment. Australia has one of the world's most vibrant and dynamic economies, with seventeen years of unbroken growth behind it, and a dominant position as the primary supply of raw materials to Asia ahead of it. It has sailed through the recent credit crisis largely unscathed, and among major currencies, the Australian dollar has posted the strongest performance in the world over the last year. Australia is an outlier among the world’s economies, and several readers have wondered whether Australia will be able to continue playing by its own rules in the future.

Australia’s relationship with China is much like the relationship between Canada and the United States, so any analysis of Australia's mid-term economic prospects hinges upon the dynamics occurring within the Chinese economy. Chinese stimulus efforts have had an outsized impact on commodity markets, as heavy government spending on resource-intensive infrastructure projects has boosted demand for raw materials over the last year. This has translated into strong export growth in Australia, and has contributed to rising employment and inflation numbers in recent months. The outlook for Chinese stimulus efforts is quite uncertain; while a political mandate clearly exists to support economic growth, inflationary pressures and lending excesses represent significant challenges to future spending. As is the case elsewhere in the world, Chinese authorities are beginning to call for a reduction in stimulus expenditures, and many observers expect to see government-driven spending slowing through the early part of next year. According to several commodities analysts, Chinese importers have largely rebuilt depleted inventories of metallurgical coal and iron ore used in steel production, and stockpiles of other raw materials are rapidly approaching capacity. Over the long run, commodity demand should remain strong as China and many other Asian nations build the infrastructure needed to support future economic growth, but it seems that a shorter-term demand-side correction is coming, and this may manifest itself in lower imports.

Australia’s domestic housing market is quite frothy. In contrast to the huge declines seen elsewhere in the developed world, new home sales surged almost 25% this year, and prices have risen 6.1% since February. Values are sitting well above their 2008 peaks, treble their values in 1996, contrasting with the declines seen in much of the rest of the developed world. Much of this is due to government intervention; tax cuts, grants, and lowered interest rates have all played significant roles in driving the frenzy. In common with their Canadian counterparts, officials at the Reserve Bank of Australia (RBA) have repeatedly issued warnings of overheating in the real estate markets, and both rate hikes over the last month were accompanied by statements expressing concern about asset price increases. Most analysts see “neutral” interest rates in the 5 – 6% range, and the central bank is rapidly tightening policy. Roughly 90% of Australian mortgages are indexed to prime rates, meaning that interest rate hikes are directly translated into costs for most homeowners, unlike the fixed rate regime in Canada. This capacity and commitment towards reducing asset price inflation should help to cool the market over time without recourse to regulatory pressure, making an outright housing price collapse unlikely.

While a close relationship with China and an overheating real estate market do represent short-term risks, Australia's fiscal position is extremely strong, putting the economy on a strong footing in the long term. Treasurer Wayne Swan recently forecast net government debt levels peaking at around 10% of GDP in 2014. This is in marked contrast to the rest of the developed world, where debt levels will hit an average 80% of GDP over the same time period. Canada will be closer to 90% and the United States will hit 115%. This means that Australians are in the enviable position of having the governmental resources to adapt to changing economic fortunes relatively quickly, and paying much less to maintain the debt burden over time. With benchmark interest rates sitting well above those in other countries, the RBA has plenty of ammunition to fire in the event that exports to Asia drop or the world economy takes a turn for the worse.

Interest rate differentials continue to widen as the RBA tightens, and counterparts around the world pledge to maintain loose monetary conditions. Commodity prices continue to strengthen, and Chinese growth continues apace. Currency traders have anticipated and considered these conditions for some time, and the Aussie’s outperformance has been the result. The Aussie has appreciated 30% against the Canadian dollar and 50% against the US dollar since the credit crisis hit, and further strength seems to be in the cards over the next few months. However, at this point in time it seems that much of the short-term good news has been priced into the currency and very little of the medium-term risk has been ignored. If our recent prognostications with regards to asset price bubbles and the worldwide carry trade prove to be accurate, commodity prices may drop substantially at some point during the next year. In such an event, the Aussie may fall 10 – 15% as trade balances with Asia are temporarily adjusted downwards. Either way, a break through par against the US dollar looks quite unlikely for now.

On balance, demand should prove durable over longer time periods and the outlook for the Australian economy is strongly favourable. Much of the Australian dollar’s recent appreciation has been driven by speculative flows, so any reversal would simply nurture future competitiveness. Prudent fiscal management and a willingness to act against asset bubbles have built a strong foundation for economic growth. Australia will play in a league of its own for some time yet.

By Karl Schamotta, Market Analyst
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