Fed danger for our dollar

Suddenly everything is going against the Australian dollar. The so-called yield game that underpinned our currency is turning full circle and depressing the currency while prices of both agricultural and mineral commodities are falling.

In theory it still make sense to borrow at token rates overseas and invest in higher Australian yields, but debt markets run on forecasts and the current forecasts show Australia is set to move from a high yield currency to a low yield currency.

That means either our interest rates rise or our currency gets a hiding. And the man who has a big influence on interest rates, Reserve Bank governor Glenn Stevens, wants the currency to come down further

Overseas investors playing the yield game have already suffered big currency losses and so are in danger of suffering more.

Let’s go though the forecasts – and here I am indebted to Westpac chief economist Bill Evans (Weekend Economist: The Fed factor, October 3).

The federal funds rate is the rate at which US banks and other depository institutions lend money to each other and is used to control the supply of available funds and other interest rates.

The current federal funds rate is just 0.25 per cent. The mid-September meeting of the Federal Open Market Committee (FOMC), showed that the average view amongst FOMC members was for the federal funds rate to reach 1.5 per cent by the end of 2015 and 3.0 per cent by end 2016.

But as Bill Evans points out, the people on the Federal Open Market Committee whom he calls the “reasonable doves” are believed to be none other than the chair of the Federal Reserve Board Janet Yellen and the FOMC vice chair William Dudley.

They will have a big say in what happens and their forecasts are for the federal funds rate to be much lower than the average . The doves expect the rate to increase to only 0.4 per cent in 2015 but to rise to 1.5 per cent in 2016 – in other words they are a year behind the average FOMC members.

The current US money markets have split the difference, with a target rate for the end of 2015 at 0.75 per cent and by the end 2016 at 1.75 per cent.

So let’s use those forecasts and compare them to what is forecast for Australia. The market is expecting only a 30 per cent probability of one rate hike by end 2015, and only one full 25 basis point move through the whole of 2016. In other words while US interest rates rise substantially the market reckons our rates will rise only marginally presumably because of the state of our economy in relation to the rest of the world.

In the 15 years prior to the global financial crisis the Reserve Bank cash rate averaged 1.5 per cent basis points higher than the federal funds rate.

On the basis that the market expects the federal funds rate to be 0.75 per cent by the end of 2015, our rate should be 2.25 per cent, which is in line with actuality. But in 2016 a US federal funds rate of 1.75 per cent would indicate a Reserve Bank cash rate for Australia of 3.25 per cent compared to the market forecast of 2.75 per cent.

Bill Evans, who picked the fall in Australian interest rates brilliantly, now believes that the Reserve Bank cash rate will rise to 4 per cent by the end of 2016. But that’s one economist’s view. The market is not predicting that and while the market holds with its current interest rate predictions the Australian dollar will be under pressure.

What it does underline is that investing long term in Australian interest-rate-based securities takes on an extra dimension of risk – even if the ‘reasonable doves’ are right, you will see a rise in US rates which will see a further fall in the Australian dollar unless we follow suit.