Well, the sugar addicts at the Federal Reserve lolly shop will see their supply of easy money continue for a while longer, but as Henny Penny famously said, the sky is falling, and those big brave investors/traders/hedge funds — or whatever you call them — don’t like it.
The Fed’s more upbeat outlook on the US economy and the continuing improvement in the country’s employment picture, plus low inflation and moderate but solid growth, means that after six years of recession, high and distressing levels of unemployment, a housing crunch, collapsed banks, record low interest rates and trillions of dollars in central bank easing, normality for the US economy is just around the corner. Within a few months we may see the Fed start tapering its $US85 billion a month in spending, and finishing in the middle of next year, if chairman Ben Bernanke’s comments at a Washington press conference this morning are any guide.
Our market reacted in its usual silly, follow-Wall-Street’s-lead and sold off heavily from the opening of trading this morning, shedding around $30 billion in value. The crazies are still in charge, it seems. Denial is still powerful and the need for another easy money hit overwhelming. Time for an intervention?
Despite the ensuing sky-is-falling sell-off in the markets, this is good news for the US and the world. The main negative is that the free ride investors have had for much of the past five years will end and they will have to start pricing in risk, return and the cost of money again — as per normal economic times.
And a decision from the Fed to start slowing its spending (which is in effect a tightening of monetary policy) could be the first policy test for a new Australian government after the September 14 election. The Fed meets the following week for two days and is widely expected to reveal its tapering thinking at that meeting.
It could be an early baptism for Prime Minister Tony Abbott and Treasurer Joe Hockey, especially if the value of the Aussie dollar continues to fall and the markets keep responding with volatility.
After Bernanke’s statement, markets went down in the US and Asia and up went US interest rates and the US dollar. And, importantly for Australia, down, down, down went the Aussie dollar — losing 3 cents in a day to trade closer to 92 US cents than above 95 US cents a day ago. It is now around 12% below its highs in January this year of around $US1.05.
And that’s unalloyed good news for Australia (and for whoever wins the election), even despite the inflationary impact, because it will help the economy rebalance more quickly by improving export returns, limiting the slide in our terms of trade, and stabilising national income. It’s what the Reserve Bank wants to see, as it explained in the minutes of the June policy-making board meeting:
“The exchange rate had also depreciated noticeably, though it remained at a high level considering the decline in export prices that had taken place over the past year and a half. It was possible that the exchange rate would depreciate further over time as the terms of trade declined, which would help to foster a rebalancing of growth in the economy.”
That’s not to say there aren’t problems on the horizon. The Fed’s tapering has to be done without spooking markets and causing interest rates to spike. The 0.70% surge in US 10-year bond yields since May 22 when Bernanke indicated a decision on slowing the Fed’s spending could come “in the next few meetings” shows how delicate this process will be. Another spike would trigger a sell-off around the world, which could leave markets back where they were a year ago — unhappy, nervous and with banks and other financial institutions facing huge potential losses, especially in Europe.
“The damage to the value of the Australian dollar and domestic interest rates from any change among Japanese investors could halt the economy.”
But the way the Fed is gradually softening up markets for the change seems to say that a panic won’t happen (hopefully). Of greater immediate importance to Australia is the sudden credit crunch in Chinese financial markets this week as the country’s central bank attempts to control lending and the unchecked growth in short-term financial products.
For Australia, the continued health of the financial system of our biggest trading partner and major buyer of our biggest export, iron ore, is of greatest importance. Any misstep by the Chinese authorities which causes a credit crunch would affect us. The central bank has refused to provide liquidity to the country’s financial markets, forcing short-term interest rates to around 8% in what is seen as an attempt to slow the pace of credit expansion and house price rises (much of which seems to be financed by a plethora of new, short-term wealth management products, as they are called in China). It’s high-risk.
The Reserve Bank is also concerned about Japan’s attempts to quickly reflate itself out of its deflationary rut, saying in the June minutes:
“In Japan, financial market participants had been weighing up two competing forces: the direct, downward pressure on yields from bond purchases by the Bank of Japan versus the upward pressure from expectations that these purchases would succeed in reflating the economy. The net result had been a marked increase in volatility and higher bond yields in Japan. Members noted that, while Japanese investors had shifted out of bonds and into equities, there had been little evidence to date of a shift into foreign bonds. Nonetheless, if it occurred, such a shift had the potential to affect Australian foreign exchange and debt markets. Despite Japanese investors allocating a relatively small share of their holdings of foreign debt securities to Australia, the absolute value of this allocation was large relative to the size of both Australian debt markets and capital inflows.”
The RBA never expressed so openly similar fears about the impact of the Fed’s three quantitative easings since 2008. It fears Australia could be collateral damage if the Japanese get their reflation attempt wrong. Already there are fears that it will mis-manage it — that’s partly the reason for the 20% plunge in the Japanese sharemarket since mid-May and the sharp rebound in the value of the yen.
Of the three challenges, Japan is the most worrying for the RBA because of greater uncertainty and unpredictability. The damage to the value of the Australian dollar and domestic interest rates from any change among Japanese investors could halt the economy. If that was to occur with the tapering in the US and tight credit conditions in China, then the new Australian government’s ability to ride out these shocks would be sorely tested at the start of its term.