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Australia cannot afford a currency war

by Craig Swanger | Mar 05, 2015

On Tuesday, the RBA chose to leave rates on hold, but made it clear that they would likely cut another 25 basis points (0.25%) in the near future. 

We seldom criticise the RBA, mostly because there is little point arguing with the referee. But this time there is a point: a warning of things to come for term deposit investors if the RBA maintains its current policy.

So the criticism is this: further reductions will achieve little other than to reduce the income of term deposit investors even further. The purpose of monetary policy is to manage the economy. The RBA raises rates to discourage borrowing and therefore take the heat out of the economy; and it lowers interest rates to encourage borrowing to fuel a slowing economy.  This time is different though. Now the RBA is lowering rates to take part in a global currency war, with the other combatants being three of the four largest economies in the world: China, Japan and the EU. 

Ordinarily, lower interest rates in Australia will lead to a lower Australian dollar. This is simply because international investors will find our interest earning investments less attractive when rates fall.  But that is only when our rates fall faster than other countries’ rates. If our rates and theirs fall at the same time, currencies are unlikely to move.   

And that is the point. The RBA is attempting to outgun three massive central banks – Europe’s ECB; Japan’s BoJ and China’s PBoC – all trying to lower their currencies at the same time.  Why are they all doing this? For the same reason as the RBA – a lower currency makes our export products cheaper to offshore buyers, which in turn boosts the economy. We are in the midst of a global currency war in which interest rates are being used as weapons and Quantitative Easing (QE) as the nuclear response when the conventional weapons no longer work.   

China surprised the world by lowering its interest rates on Saturday. This was several months ahead of markets’ expectations. And the BoJ and ECB continue their QE measures, pushing real interest rates into negative territory (effectively paying the banks to borrow money from the central bank). QE is now at its highest level globally, which is alarming when we are six years out from the GFC.

In all cases – China, Japan, Europe and Australia – it is having an impact, but not the right one.  Housing and equity market prices are rising steeply, but the real economy is not seeing the benefits that warrant the measures. The US and UK QE campaigns both succeeded in impacting the real economy because they came swiftly after the GFC, increasing asset prices immediately and restoring business and consumer confidence. In the case of Japan and Europe, it is too late. Confidence has been impacted and left a long-term scar. So they are now resorting to a currency war to boost exports. 

For now, there are three implications for income-seeking investors: 

  1. The RBA seems determined to join in the currency war. With most of the other major pairs joining in, there are two currencies that the AUD is likely to fall against: the USD and the GBP. The further the Australian economy falls, the harder the RBA will push, and the more the USD and GBP will rise against the AUD. In other words, investments in these currencies will serve as a natural hedge against falling interest rates in Australia.
  2. Unless the AUD falls on its own accord or Australian economy starts to recover, the RBA will force term deposits rates lower. Investors could protect against this risk by locking in fixed rates on their deposits now.  
  3. The risks of an equity market and housing market bubble are rising with each rate cut.  Quality investments as opposed to just chasing yield, is the key, regardless of the asset class. Investors should also ensure they can ride out any medium-term corrections such as that witnessed in 1987, 2000 and 2007.  

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