Strong AUD could create problems with inflation: Tyndall AM

EQT expands private wealth services business
April 9, 2013
It’s unlikely, but there could still be super changes in the Budget: HLB Mann Judd
April 12, 2013

The strength of the Australian dollar is likely to continue in the short to medium term, with significant implications for the Reserve Bank of Australia’s (RBA) monetary policy and its ability to manage inflation in the longer term, says Roger Bridges, head of fixed income at Tyndall AM.

“In my view, as long as global uncertainty and problems in Europe and, to an extent, the US persist, the behaviour of the Australian dollar (AUD) is unlikely to change significantly.

“I also believe that the domestic economy is on a slower growth path as it continues to adjust to a high AUD and the RBA is setting monetary policy to accommodate this period of adjustment.

“In the short term we will experience lower official interest rates as the rest of the world continues to de-lever and the continuation of foreign quantitative easing (QE) programs keep the AUD strong.

“The currency will most likely continue to remain strong in the near term, which should restrain inflation, allowing the RBA to keep interest rates at these lower levels.

“However, in the longer term, as the AUD stabilises and the economy continues to adjust to accommodate it, the effect of the AUD on containing inflation will wear off (as it began to in the December quarter of 2012).

“For interest rates to remain low, inflation (and the outlook for it) needs to remain stable. This either requires domestic inflation to fall or the AUD to not depreciate. If the strength in the AUD is a direct result of overseas QE programs, we could see the official cash rate rising as these programs reverse and the upward pressure they are exerting on the AUD starts to dissipate,” Mr Bridges said.

He said that for the time being, the main drivers of the strong AUD show no sign of disappearing.  These drivers include:

  • Australia remains one of the few remaining countries with a stable AAA rating.  Even the US has lost its coveted AAA status, with many other major economies on a negative outlook. This creates demand for Australia’s relatively ‘safe’ assets.
  • By running deficits during the GFC, the Australian government has effectively re-established a large and deep government bond market.  This extra supply may have created its own demand as more central banks look to the AUD as a currency to diversify into, while they reduce their weights in the US dollar (USD) and Euro.
  • The effect of the mining capital expenditure boom is another factor in the AUD’s strength.  A recent research paper from the RBA highlights that net foreign investment into the resources sector increased from 0.5 percent of GDP in 2007 to 3 percent in 2012. This foreign direct investment in the mining sector to fund new projects has exerted upward pressure on the AUD.
  • Many of the world’s central banks have used QE to stimulate their country’s weak economy, hoping to push investors into equities and riskier assets than government bonds as they search for greater yield. Essentially, this means that the bank increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity. Another objective of this policy is to weaken the home country’s currency.  For a country like Australia that has a floating currency and is not itself engaging in QE, the result is that its currency appreciates as these policies unfold.

“The easier monetary policy from the US, and now Japan, is essentially being imported into Australia’s economy, pushing up our currency.

“Although Australia has an independent monetary system, the rising currency can still result in easier monetary policy here.  Exchange rate sensitive sectors are suffering as the currency remains strong, making them less competitive than peers in countries with a weaker currency.

“In addition, the stronger dollar helps to keep top-line inflation subdued, which has allowed the RBA to cut official interest rates over the last year or so.  While domestic inflation has not fallen, international or tradeables inflation has plunged due to the strong currency, dragging down the headline inflation figure and keeping inflation within the RBA’s target band.

“In fact, domestic inflation is still very high, being above the RBA’s two to three percent inflation target.

“Furthermore, the effect of the stronger dollar on tradeable inflation is starting to wane and there has been a marked pick up over the past six months. This may be due to improvements in domestic productivity as the economy adjusts to the ‘new normal’ rate of the AUD.

However, domestic consumer and business confidence levels are at historical low levels and, in some cases, are worse than in countries experiencing much greater economic problems.

“Some of this can be explained by the bad news from overseas and the fact the Australian economy is going through a structural rebalancing, which is causing uncertainty.

“Much of the structural change is due to the strong AUD forcing businesses to readjust to accommodate it and improve productivity,” Mr Bridges said.

Tyndall AM is a multi-specialist Australian investment manager, offering investment funds in Australian shares, Australian and international fixed interest, and alternative assets, as well as a multi-manager capability to retail and institutional investors in Australia.  It has approximately A$23 billion in funds under management (as at 31 December 2012).

Tyndall AM is a wholly owned subsidiary of Nikko Asset Management Co., Ltd., one of the largest asset manager headquartered in Asia with approximately A$149 billion in funds under management (as at 31 December 2012).

-oOo-

 For more information please contact:

Roger Bridges – Phone: 02 8072 6350

 

9 April 2013