Rising Aussie dollar defies inflation logic
Rising Aussie dollar defies inflation logic
The Aussie dollar and inflation are rising in tandem. How long can the relationship last?
It’s got me stumped why exchange rates go up when inflation goes up. I’ve heard the spiel a thousand times: higher inflation means higher interest rates and higher interest rates mean everyone wants to own the currency. I still don’t get it. Over a decent period of time, high inflation has to equate to a depreciating currency. That’s what inflation is – the depreciation of money. If the currency doesn’t depreciate, you end up with absurd situations where everything in the country with inflation costs ten times more, in real terms, than in the country without it. And you could in theory print as much money as you wanted and buy the rest of the world’s assets, goods and services. That’s the path we’re headed down, but I doubt the rest of the world will let us get away with it. Yesterday’s CPI data sent a strong message to the few remaining economists contending that inflation is not an issue: you’re wrong. Most of us have known prices are going through the roof for quite a while, but it seems even the official bean counters have run out of items to exclude from the ‘core’ number. The real number is undoubtedly higher than the 4.2% reported, but even that’s enough to have everyone concerned. In stark contrast to the US, growth in money supply (M3) here is rampant – it’s currently growing at a year-over-year rate in excess of 20% – and until the Reserve Bank slows it down, the problem is not going to go away. The dollar bounced this week, but the rest of the world won’t let us get away with printing money and running a huge current account deficit forever. There are a couple of arguments in favour of the Aussie. One is that we have a lot of stuff in the ground that the rest of the world needs to buy, and for that they need our money. Another is that inflation is a global problem, not a domestic one. Currencies are, after all, relative and if inflation is on the rise everywhere, we’re relatively fine. That doesn’t explain why the Aussie dollar rises when we report a high inflation number, but it does at least have some logic to it. I certainly agree that we’re in for a serious bout of global inflation, but I don’t know that it’s going to help our situation, even in a relative sense. It’s more likely that this only adds to our existing problems. There aren’t many attractive alternatives and it’s partly a case of picking your poison. But I’m bearish on the Aussie dollar.
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Leaving the mechanics aside for one moment, and admitting that forecasting currencies is a mugs game, it strikes me that you couldn't possibly ask for a more supportive environment for the $A than what it's enjoyed recently. Commodity prices have gone through the roof, our interest rates have moved in the opposite direction to the US and our economy has been booming, surely this is about as good as it gets. That's not to say that the currency will fall any time soon, just that we should expect some sort of realignment over the longer term as the US economy deals with its problems (which might get much worse before they get better). As the text books will tell you, interest rates might move currencies in the short term, but purchasing power parity is usually restored in the long run. Lesson: inflation will eventually drive currency expectations.
It seems increasingly likely that the economic stuggles in North America will continue at least for the short to medium term. Most seem to believe that Australia's economy is sustainable for the medium term as well.
Assuming this is correct wouldn't the disparity between the interest rates in Australia and the US cause the Aussie dollar to maintain or even increase it's relative value?
Would you say that my assumptions on the economies or their effect on currency is incorrect?
Interesting ideas steve. Trading currencies is about as far from value investing as you can get. Its hard enough to value one economy let alone value it relative to another. Currency trading is all about short term flows. No room for 10 yr forcasts in this mkt. So i am somewhat surprised you wish to dip you toe into this murky water. However i did luv the absurd scenario you presented. I have to agree, Paulen Hanson economic (mis)managment would have seen our dollar tumble.
Inflation however is but one small driver in the price of a currency. As you noted there are many reasons to be bullish AUD. Demand for commodities, Interst rate differentials, Asian economic growth, improving terms of trade, forthcoming tax cuts, record low unemployment, Soverign diversification out of USD...the list goes on...
So you see, you need to view the full picture to get an idea of a currencies value. And when you do you relalise it is nigh on impossiblt to predict movements with any certainty. Which is why when im not trading currencies for my bank i dont punt my own cash in currencies. i back you and your team to do a much better job with my money.....
leave fx to the muds like moi.
I don't know why would anyone want to take a punt at FX. You have the RBA phoning their mates at the Fed/ECB to coordinate the values of FX. Small players like all of us stand to lose against those big boys.
But what has all this got to do with value investing? Huh?
Steve, I would like to know what the possible ramificatiosn could be if inflation does continue to grow or at least remain high. Kerr Neilson is concerned that this will happen as are many pundits but an overview on the fallout would be appreciated for someone who hasn't studied economics.
You're better off asking Professor Steve Keen this question at http://www.debunkingeconomics.com/. He's got heaps to say about inflation, deflation and Australia's coming debt crisis.
Real inflation
I absolutely agree with your statement relating to inflation “The real number is undoubtedly higher than the 4.2% reported”
Governments are using inaccurate measures of inflation (ie the CPI) to manipulate “real” measures of wages growth to create an illusion that the economy is performing better than it really is.
A major reason for the CPI being a poor measure of inflation is due to the removal of the “interest on mortgages” from the basket of goods used to determine it. This occurred back in the late 1980’s when interest rates were very high.
Recent figures published in The Australian indicate that the average Australian is spending around 13% of household income paying the mortgage. Add to this the fact that housing prices in some areas have increased at rates of 20% per annum and you have a basis of arguing that the housing cost component of inflation by itself is worth 2.6% (ie 13% of 20%)
And the RBA leaves out food and fuel from the core inflation figures. Who does not eat and use fuel?
Steve will ultimately be right and what Ben Graham said about the stock market being a voting machine in the short run and a weighing machine in the long run equally applies to FX markets. Meaning long-term FX positions can also be value plays now and then. After 11 years in FX markets the only people I saw make consistent money from holding FX positions was the RBA (who made bucket loads) pursuing exactly what Steve is talking about but in the name of smoothing. At the moment there is a traffic jam as exporters, speculators etc try to buy as much Aussie as they can (all at the same time) and importers and other sellers push back their hedging in anticipation of higher rates – all doing what looks obvious in the short to medium term. This all takes time as the buying and selling works its way through the system (look back at the time the AUD spent in the .50's). Eventually the over zealous buying runs into the realistic selling as big money focuses on the inflationary expectation component of local interest rates, the party ends and the importers who didn’t hedge enough chase the currency down and the exporters are already fully hedged at higher levels. It happens this way time after time and nearly everyone is always surprised. Unfortunately just because you know the cycle doesn’t mean you know the top of the exchange rate.
The real issue for me is when the currency starts falling and we start importing further serious inflation what happens then?
I have done my bit to drive down the demand for Australian currency -- I took a holiday in Japan. It is fantastic what 15 years if stagnation can do to make a holiday there affordable!!! My impression was that there is no early end in sight for their problems. Maybe that there seem to be a lot of young people in service industries is a worry there just as it is here. Apprentices ? What Apprentices???? Howard fiddled while we all now burn.
i agree with the views posted here.
there is no fundamental argument to be bearish on the Aussie dollar.
If commodity prices stay high ie iron ore / coal and the USA continues to slow (GDP) We could see The Aussie Dollar at $1.20.
I think the result will depend on whether we are in a commodity cycle about to top out or whether The China India Govt balance sheets will hold up and drive the cycle for longer than usual.
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