The Reserve Bank of Australia has a problem. It is relying upon a United States recovery and hawkish Federal Reserve to bring down the Australian dollar. But although US bond markets are beginning to price interest rates rises in the US, they are only doing so at the short end of the curve. Longer duration bonds are the ones that determine carry trades from cheap US dollars into the higher interest rates of other nations and they aren’t buying what the Federal Reserve is selling.

Friday evening saw more bullish Australian dollar action. It was a night of subtle “risk off” but not for the Aussie, piling on 0.5% and threatening 91 cents again:

The long-term chart is now unmistakably bullish, with an inverted head and shoulders bottom and ascending triangle forming:

The recent commitment of traders report is also showing large and small speculators covering their shorts:

Not yet net long but trending that way. So, what’s going on? Unusual moves in US bond markets is what. Last week saw lots of comment about the Fed’s hawkish shift and its effects on the US yield curve. Sober Look has a nice summary.

Long bond yields still look more likely to fall than rise; indeed the 10- and 30-year yields both fell 1% and more Friday. The 30-year especially has a bearish chart:

The 10-year not quite so much:

The US bond market is paying attention to a hawkish Fed but is also dismissing its long-term forecasts. Last week the Fed raised its 2016 year-end forecast for the cash rate to 2.25%. The last time the US cash rate was at that level was in March 2008 and the 10- and 30-year yield were at 4%. The time before that, in 2005, both were at 4.5%. But right now, the 10-year and 30-year are only at 2.75% and 3.6% respectively.

US bond markets are pricing the Fed’s attempt to reach its tightening targets but they’re also pricing the failure to get there.

There are reasons to think that the Fed (and RBA) is right and that longer duration bonds will follow. But there is still considerable slack in the US economy — enough to contain inflation — and there is likely to be more dis-inflationary pressure from Chinese tightening and the steady deflation of the commodities complex that is underway as result.

Even if the recovery has enough momentum to reach the Fed’s growth targets there is unlikely to be much inflation. Hence the yield curve may remain flat.

Given the yield spread on the 10-year bond is the dominant benchmark for carry trades, that is the worst of both world’s for Australia because, even though the US tightens, its recalcitrant bond market won’t allow any compression in the yield spread with Australia:

Meanwhile, in Australia, the RBA’s revitalised housing bubble has more and more folks looking “across the valley” of the mining capex cliff to rate hikes. They’re probably wrong, not least because the expectation is self-defeating in that without a lower dollar there’ll be no sustained recovery, but that’s not the point right now.

So long as the US long bond market flips the bird at the Fed then the Australian dollar is going to be under upwards pressure.

The answer is still the macroprudential tools mentioned obliquely in the RBA minutes last week. Temporary prudential controls on credit will allow interest rates to be cut and will bring down the dollar so that the Australian recovery can progress.

*This article was originally published at MacroBusiness

Peter Fray

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