I am reaching the end of a two week trip in Europe and the UK visiting central banks; hedge funds and real money managers. Not surprisingly the key theme has been around the record low volatility in markets and concerns that some major shock may be imminent.
Despite those concerns, carry trades have been the dominant theme. In that regard the carry trade of long the Australian dollar short one the euro has been a common theme. Other carry trades around emerging markets are also popular.
There is one very pragmatic reason behind the popularity of the long Australian dollar/short euro trade – a recent history of consistent losses on the long US dollar/short euro trade in the earlier part of the year. This theme, of course, has been unpopular with the Reserve Bank which has noticed a rise in the Australian dollar, up 5 per cent on a TWI basis, since the beginning of the year despite a fall of 15 per cent in Westpac’s index of bulk commodities.
However, it was my strong recommendation to customers that a further major leg down in iron prices was unlikely given that prices were now down around the breakeven levels of the high cost Chinese mines – a further sharp fall is likely to precipitate production slowdowns which would allow exporters to lift prices.
The case for a weaker euro seemed to strengthen since the recent ECB announcements. With €170 billion ($A244.8bn) of ECB deposits being released (coupled with a further €100bn in excess reserves which are unlikely to remain at negative interest rates) there is a realistic probability that banks will seek to invest these excess funds outside the euro area given the poor value being offered from a credit risk perspective in most European sovereign bonds. That dynamic appears to be a clear objective of that aspect of the new ECB policy.
While that credit issue would seem to be the overwhelming key driver of a move out of periphery bonds there was still the argument, put by some, that real yields are lower in Italy/Spain/Greece and thus represent better value than US/Australian bonds.
The other key policy around offering €400bn in funding for corporate/commercial loans at 0.25 per cent for four years seems likely to further lower yields in that part of the curve – quality corporate borrowers will be able to access even cheaper funding through the banks than in the corporate bond market.
Of course those folks like myself who expected that the only workable solution to the lack of competitiveness of the European periphery was to leave the Euro are not surprised by the deflation that is now afflicting the periphery and which seems to be of such concern to the ECB. Without adopting a different currency the only other solution to restoring competitiveness is internal deflation or a lift in inflation in the core – Germany seems highly unlikely to allow the latter.
These issues in the European markets emphasise that markets are unlikely to move in synchronisation.
With the US economy moving towards a Fed tightening and US bond rates likely to eventually move up in yield in anticipation of the tightening it is reasonable to expect a significant decoupling between the US and Europe.
Of course there was much discussion around the timing of the Fed’s first move. Some expect that the chairman is now focussed on financial stability and are mindful of recent statements from FOMC members with more emphasis on financial stability. Others expect that the case has already been made around the labour market on the basis that the unemployment rate is already around the Fed’s original target and the fall in the participation rate has been structural.
I was more convinced (possibly reassured because it coincides with the Westpac view) that the first tightening is likely to be around 18 months away. Certainly, over the years, I have been able to assess the reliability of many of these people I have visited consistently and the ones with the best records are on the dovish side.
I was even encouraged that one customer “bought” my argument that, unlike in Australia, household balance sheets are not in good condition in the US, particularly given the consistent falls in the savings rate. The lift in growth will have to come from business, which will eventually have to move from cost cutting/share buy-backs to M&A (happening now), neither of which have high growth multipliers to "building" rather than “buying". That will come as equity markets continue to appreciate in an environment of a compliant Fed over the next 18 months. As valuations rise, companies will find it more cost effective to build (invest and employ) rather than buy. Growth strategies will also be necessary to justify high valuations.
The above discussion does not mean that most meetings concentrated on non Australian issues. Indeed most meetings were around Westpac’s Australian views. We had general agreement around our view that the RBA would remain on hold until the second half of 2015. There seemed to be little support for the majority view of economists that cash rates will be increased by late 2014/very early 2015.
Only one customer was sufficiently impressed by the recent slowdown in housing and consumer spending to call a rate cut by year’s end.
Support for our Australian dollar view that the Aussie would revert back to fundamentals through 2014, ending the year around USD 0.90¢, was in short supply. The resilience and popularity of the carry trade seems dominant to most investors at this stage of the cycle.
Bill Evans is chief economist with Westpac.