With hindsight, the timing of the Reserve Bank’s latest cut to official interest rates was fortuitous.
The Reserve Bank, of course, had no idea that The Wall Street Journal was about to publish an article saying that the US Federal Reserve Board has developed a strategy for a staged winding back of its $US85 billion a month purchases of government bonds and mortgages.
The modest contraction in the yield premium on offer from government bonds in this market relative to the near-zero rates on offer elsewhere, however, was perfectly timed to almost coincide with the Journal’s piece, which triggered significant buying of the US dollar and pushed the Australian dollar slightly below parity.
The behaviour of the dollar since Friday, when it appears the markets may have got wind of the Journal’s report, reinforces the view that the unusual strength of the Australian dollar and the breaking down of the historical correlation of the dollar and commodity prices has been due more to other countries debasing their own currencies than to local influences.
It has been apparent from the minutes of recent Fed Open Market Committee meetings that the members of that committee have become increasingly concerned about the potential for the protracted period of loose monetary policy to encourage excessive risk-taking and financial imbalances and that there has been serious consideration given to ending the quantitative easing program before the end of this year.
According to the Journal the Fed is unlikely to simply stop buying bonds and mortgages, instead it may wind back the scale of the purchases over time to take stock of the impact on the US economy and, in particular, the US job market.
The markets, of course, move in anticipation of policy changes and therefore the signals coming out of the Fed about the QE program have the potential to cause big shifts in capital flows, both between geographies and within markets.
While the loose monetary policies being pursued in the US, Europe and Japan have been the major influence on the continuing strength of the Australian dollar despite the big fall in commodity prices that has occurred since they peaked last year, there have been some Australia-specific factors.
One of them, of course, was the appeal of the positive returns available in this market, which the Reserve Bank has shaved.
Reserve Bank assistant governor Guy Debelle gave an important speech last month in which he referred to the impact of big shifts in capital flows into this economy.
Foreign capital inflows, he said, had grown from about 1 per cent of GDP in 2007 to about 3.5 per cent last year.
Foreign purchases of government debt had seen foreign ownership of Commonwealth government securities rise from 50 per cent to about 70 per cent. That’s clearly related to the monetary policies being pursued elsewhere and the positive yields and perceived safe-haven status of this market.
Debelle also, however, talked about the capital inflows to the resources sector, which he estimated as being around 80 per cent of the funding for the investment boom.
While there was an offsetting factor because of the big shift in the funding of the banking sector as it has massively reduced its offshore borrowing since the financial crisis, Debelle said the net effect of the shifts in capital flows was that the value of the Australian dollar was higher than would otherwise be expected.
The resources investment boom is, of course, expected to peak within the next 12 months and then, once those projects still underway are completed – mainly the export LNG plants under construction in Queensland and off the coast of Western Australia – to then fall away dramatically.
So, if the main forces that have underpinned the historically high levels at which the Australian dollar has traded post-crisis – the US quantitative easing programs and the inflows of capital to fund the investment boom – begin to fade, the dollar may slide further and reduce some of the pressure on the non-resource sectors of the economy.
The probability that the US will be very cautious about how it exits those programs and the fact that even if it peaks the investment in those big resource projects now under construction will still be substantial over the next two or three years, means there should still be strong support from inflows of capital for the Australian dollar but there could be significant volatility in our markets as the turning point in the QE programs looms.