Australia and India Raise Rates

Yesterday was busy here on the desk, with the normal flurry of Monday trading combined with a number of calls to the desk regarding our MarketSafe CD which will be closing out shortly. But the currency markets were fairly quiet ahead of the elections today. But as I pointed out yesterday, trading yesterday was nothing more than the quiet before the storm, as the currency markets were rocked overnight with surprise rate announcements by both Australia and India. I warned you that this week was going to get interesting.

The big news overnight was the Reserve Bank of Australia’s announcement that they would add another quarter point to their benchmark interest rate in order to steer their economy clear of inflationary pressures. The move pushed the Aussie dollar (AUD) to above parity for the first time in nearly 30 years. I pulled a chart of the Aussie dollar which shows that it moved through $1.00 on July 30, 1982 and hasn’t revisited this level since. 1982 was a great year for yours truly, as I was enjoying my last year in high school, listening to Billy Squier and watching MTV. For those of you who don’t believe the Aussie dollar can move above parity, it had traded all the way up to 1.49 back in 1973 (when Chuck was enjoying his senior year in high school!) But we will have to wait a while before we see those kind of levels again as the Aussie dollar couldn’t hold the $1.00 level last night and moved back just below parity as of this morning.

This was the first move by the RBA in 6 months, and caught most economists off guard. RBA Governor Glenn Stevens said the economy has “relatively modest amounts of spare capacity” and citing risk of inflation rising again over the medium term in his statement following the rate increase. Australia’s economy has been enjoying what looks like a very sustainable level of growth with unemployment at just 5.1% and inflation running at a modest 2.8%. But pressure on commodity prices has the RBA worried about inflation risks, and prompted RBA Governor Stevens to take action. This is one reason the Aussie dollar has been such a long-time favorite of the desk; the RBA has done a fantastic job of being proactive, and steering their economy through the global downturn.

The move by Australia also helped their sister currency, the New Zealand dollar (NZD), which moved solidly above 0.77 cents. The kiwi was also helped by a report which showed wages in New Zealand increased which could force a move on the part of New Zealand’s central bank. The kiwi may be a good alternative for those investors who feel they already have too much of their portfolio invested in the Aussie dollar. Both countries look to continue raising their rates, and commodity prices should stay strong with the growth in the Asian region.

Shortly after Australia announced their interest rate move, India joined in with a similar 0.25% move. India’s move was squarely aimed at reducing what is the fastest inflation rate among developed nations. Consumer prices rose just under 10% in India during the month of September. Reserve Bank of India Governor Duvvuri Subbarao said he expects inflation to slow to just 5.5% during the first quarter of 2011 and the economy to expand 8.5%. But he also sounded a word of caution to currency speculators, throwing cold water on any expectations of further rate tightening in the immediate future. The Indian rupee (INR) has gained just 4.8% versus the US dollar in 2010, versus an 11.52% jump by the Aussie dollar. Part of the reason for the lagging performance of the rupee is that interest rates in India remain well below those offered in Australia and Brazil. But growth rates in India, and the sheer size of their economy has many investors comparing it to China instead of Brazil or Australia. And when you make the comparison between China and India, interest rates in India do look attractive.

The moves by Australia and India highlight something that I touched on yesterday: the global economy is on two very distinct paths right now. Countries in Asia are back on a growth path (many never left it!!) and have clearly entered a tightening mode in order to prevent inflation from growing out of control. The economies of the US, Japan, and parts of Europe are still languishing in a no-growth mode with policymakers looking to start another round of stimulus efforts. So where would you rather put your money: in economies that are growing and where you can get higher interest rates; or in economies that are stagnant with interest rates near zero. It is a pretty easy question to answer, isn’t it? This obvious answer is what is propelling the higher yielding currencies of Australia, New Zealand, India, and Brazil up versus the US dollar and euro (EUR).

But the rush into these currencies is a bit worrisome, as “hot money” is never stable and is starting to inflate what could eventually turn into a bubble. Nouriel Roubini, the NY University professor who correctly predicted the housing crash, highlighted this growing bubble in a conference early today. Roubini said, “Prices may be running ahead of economic fundamentals” but also said the “party” can go on for a while. Interest rate differentials will continue to flood these markets with cash, and their central banks will need to try and keep their currencies from appreciating too quickly. One way these central banks can try to control the currency is by building up reserves, which can be used in currency interventions, and as I pointed out yesterday, India has done just that. But Chuck has always warned that currency intervention only works in the short-term, and even countries with some of the largest reserve pools (Japan) have trouble fighting the currency markets. While I appreciate where Roubini is coming from, I agree that the party can go on for a while, and we might as well participate (I’ve never been one to miss a good party!!)

Back here in the US we have finally arrived at Election Day. Hopefully everyone will take the time to get out and vote. I know I am planning to stop by the polling place on my way home. I may have led many to believe I wouldn’t be voting with my statement yesterday when I said that it really doesn’t matter who has the helm of a rudderless ship; but I feel it is my civic duty to vote, and hope that everyone else gets out to vote also. While I do believe the debt that has accumulated over the past several years is pushing the US economy in a scary direction, which will not be avoidable, I still want folks in congress who will at least recognize that we have accumulated this debt and need to do something about it!! You have to start attacking this debt much like you eat an elephant, one bite at a time. And I would like to see members of our congress push up to the table.

But the elections are still not taking center stage in the markets here in the US. That ground is being held by the FOMC, which is set to announce the size of its new stimulus effort tomorrow afternoon. There is not really any question over whether or not they are going to announce the stimulus measures, but the questions are now just how large the stimulus will be. Most believe they will announce $500 billion of new bond purchases spread out over the next few months, but many (including Chuck) believe the actual amount will be much larger. The currency markets have “baked in” a 500B figure, so if the stimulus is anything less, we could see a rally in the US dollar. If they come clean and announce a number that is closer to what I think it will eventually turn out to be, the dollar will be sent to the woodshed. After all, if the FOMC is flooding the markets with US dollars, the value of every dollar has got to go down (according to the laws of supply/demand).

I would expect the Fed to take a cautious approach with QE2 and just announce a $500 billion package, knowing that they will likely have to come back and announce a further package sometime later. And who knows, if the dollar continues to drop (as I believe it will) our exports may actually turn the economy back around and start to pull us out of this malaise. But that theory would stand a much better chance if we still made things in the US! I think the process will be longer, as we will need innovation and the creation of new products and new markets overseas to really increase our exports enough to make a difference.

Hong Kong’s Monetary Authority was recently granted authority to invest in bonds and stocks on the Chinese mainland, giving them the ability to further diversify their currency holdings. The Hong Kong dollar (HKD) has been pegged to the US dollar for a number of years, and recent moves indicate that this peg may be scrapped in favor of a link to China’s currency. Chuck mentioned this possibility earlier this year, and many investors have been purchasing Hong Kong dollars as a surrogate to investing in the renminbi (CNY). Hong Kong’s financial markets are more advanced than those on the mainland, and there is definitely a possibility that China will decide to let the Hong Kong dollar float prior to releasing the peg on the renminbi. With a peg to the US dollar, Hong Kong’s monetary policies are tied to the US, but their economy is more closely aligned with China. We have seen a tremendous jump in the cost of forward contracts in the Chinese currency, indicating the markets believe the Chinese will take further steps to loosen their grip on the renminbi. A first step could be to let the Hong Kong float.

The metals are largely unchanged from yesterday, but they could be impacted by the election returns here in the US. The metals are seen as “safe haven” buys, and the questions surrounding the elections and the size of the FOMC stimulus efforts could definitely produce some volatility in the metals markets.

To recap, both India and Australia raised rates, starting off what will be several rate announcements in the coming days. US elections will take place today, with a change in the ownership of the house predicted. FOMC will be announcing their rate decision (most likely no move) and the size of the QEII. And finally, China may be looking to let the Hong Kong dollar float prior to releasing their tight grip on the value of the Chinese renminbi.

Chris Gaffney
for The Daily Reckoning