The Intrinsic Value of Credit

Yesterday, Glenn Stevens at the Reserve Bank of Australia did what was expected and kept interest rates on hold. And absent any major shock to the economy, rates will remain on hold for some time to come. But if you read between the lines, Stevens must be getting just a little concerned about the ability of monetary policy to haul the economy back into healthy and sustainable growth.

From his statement yesterday:

‘Financial conditions overall remain very accommodative. Long-term interest rates and risk spreads remain low. Emerging market economies are once again receiving capital inflows. Volatility in many financial prices is currently unusually low. Markets appear to be attaching a very low probability to any rise in global interest rates over the period ahead.

‘Moderate growth has been occurring in consumer demand. A strong expansion in housing construction is now under way. At the same time, resources sector investment spending is starting to decline significantly. Signs of improvement in investment intentions in some other sectors are emerging, but these plans remain tentative as firms wait for more evidence of improved conditions before committing to significant expansion. Public spending is scheduled to be subdued. Overall, the Bank still expects growth to be a little below trend over the year ahead.’

In other words, money is everywhere and easy. These financial conditions *should* generate strong economic activity. But they’re not. Instead, consumer demand is only moderate (and could get worse if sentiment readings don’t improve); resource sector spending will drop dramatically this financial year, with only tentative plans to fill this investment hole. And the government is trying (badly) to fix a structurally weak budget.

Put another way, interest rates are at historic lows, and economic growth looks like it will remain below trend this year. The terms of trade (which has a major impact on national incomes) is under pressure and our Aussie dollar remains stubbornly high.

On a positive note, China is so far managing its downturn well. Targeted stimulus seems to be keeping activity elevated. The official manufacturing PMI for June came in at 51, up from 50.8 in May (a reading over 50 indicates expansion). Activity isn’t strong, but it’s not weak either.

This is probably why the dollar remains so strong in the face of a falling terms of trade. Add to that Japan’s grand monetary experiment, which is fuelling demand for the Aussie from yield starved Japanese savers, and you have a dollar that ‘remains high by historical standards’, as the RBA put it yesterday.

Well, it’s even higher after overnight trading action. As you can see in the chart below, the Australian dollar popped last night and is now set to breach 95 US cents. The chorus of parity callers will now grow louder. But I think this rally will run out of steam before it gets there. Then the Aussie will be a sell again.

Here comes the parity chorus

click to enlarge Source: Stockcharts.com

I’m not sure why the dollar spiked so much. Was it the RBA leaving rates on hold (as expected) or was it China’s improving manufacturing data (which was also expected)? Who knows, maybe it just reflects a weaker greenback?

The Financial Review offers an innovative reason for the dollar to maintain its strength. Apparently the dollar will benefit from today’s expected trade deficit. According to the paper, ‘the local currency could find added support in Australian trade data as the rising volumes of exports comes on stream, suggesting more offshore investors are having to buy the local currency, and therefore leading to a widening of the trade deficit.’

What the? So a widening trade deficit is now good for a currency? Well, in these no-risk markets, just about anything makes sense.

I prefer to think of it like this. The Australian dollar is a high yielding currency. That’s because it’s risky (our net foreign debt levels are up to $855 billion) and we are overly reliant on one customer (China now takes in around 40% of our exports). When no one cares about risk, you can’t get enough Aussie dollars…when risk becomes an issue, you can’t dump them quick enough. End of story.

Speaking of risk, remember how the Bank for International Settlements (BIS) came out on the weekend warning of euphoric markets? Here’s the excerpt:

‘The overall impression is that the global economy is healing but remains unbalanced. Growth has picked up, but long-term prospects are not that bright. Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.’

As always happens in times of ‘euphoric markets’…warnings go unheeded. And sure enough, US markets gave the BIS the old two finger salute overnight by hitting, yet again, another record high.

Read the rest of this article at The Daily Reckoning