When the yield game ends

The $A will be re-examined on fundamentals as global events unfold … but it won’t happen for a while.

Summary: The rise and rise of the Australian dollar in the face of offshore economic and geopolitical volatility is a short- to medium-term phenomena. Eventually economic conditions in Europe and the US will end the yield game, and place pressure on our currency. But don’t expect any imminent changes.
Key take-out: As demand for Australian commodities weakens over time, especially from China, other areas will need to pick up the slack. China will need more gas, but Australian producers will face stiff offshore price competition. These factors, combined with rising rates, will affect our dollar.
Key beneficiaries: General investors. Category: Economics and investment strategy.

Morgan Stanley sent ripples through the currency markets when it forecast that there was a real possibility that before the end of 2014 the Australian dollar would reach parity with the American currency. And the latest events in Iraq have weakened the US dollar, sending our currency upwards again.

I have made a mental note that while there is clearly no hurry, it would make sense to use this Australian dollar rise to lock in overseas assets – particularly US assets. In some cases it might even be worthwhile taking some lower overseas interest rate debt.

Let me first explain why Morgan Stanley believes the Australian dollar is set to rise, and why I believe we are looking at a short- or medium-term phenomena.

In simple terms the European Central Bank (ECB) has introduced negative interest rates for banks and, as I explain later, has increased the liquidity of the European banking system. As a result, institutions are borrowing at even lower rates in Europe and investing at higher rates – sometimes in Australian currency. And that is boosting our dollar. And last night we saw that multiplied when the US dollar fell on Iraq, but yields on its government securities fell. That sent yield-seeking overseas investors clambering for Australian dollars.

But let’s step back. In the money markets there are some strange things happening. No-one is taking the slightest interest in the fundamentals, which in normal circumstances would be pushing the Australian dollar lower. Last week I informed readers that Westpac was offering a higher interest rate (4.55%) for five-year deposits, but now it has pulled in the shutters and their top five-year rate is now 4.35%. This is a fraction above its rivals, but there is not much in it.

Westpac is clearly concerned that some rival Australian banks are taking full advantage of the availability of low-cost overseas finance, so it is not a good time to be locking in higher rate local money.

On the European scene I am always jittery when there is great publicity on one aspect of a major decision, and a second aspect is completely concealed. And that is what happened with the ECB negative interest rates and lower bank rate story. Hidden in the detail was a plan to lend more money to European banks, with the expressed intention that they should loan that money to private European businesses. But if the banks invested it elsewhere – say in short-term European bonds – they would have to repay these loans within two years, but there would be no other penalty.

The exercise was really about giving the banks profit in advance of their balance sheet testing and, at the same time, to the extent that the money was invested in high-yielding European bonds, it would drive down rates on high-risk country borrowing. The cracks in the European rescue are still there and, in 2015, they will become more apparent. It is likely that sometime next year, or early 2016, interest rates will start to rise as a result of either problems in Europe or the American economy starting to accelerate.

The yield game and minerals outlook

When that happens this yield game will end, and the Australian dollar will be re-examined on the grounds of fundamentals. Our mineral trading situation is not looking good for iron ore and coal, and there is controversy over gas. It is now clear that Beijing has substantially reduced steel output in the provinces to its north to cut pollution. Many other steel plants are being shut. In the process, China is reorientating its economy away from steel usage. That doesn’t mean a slump in steel demand, but there is a lot more iron ore set to be produced and demand looks weak. It is hard to see iron ore having a good run in the next few years, but it will certainly come good in the future – that’s why patient Chinese are buying Australian iron ore development projects.

There are also very large increases in global gas supply, and much of that gas is to replace coal. Combine that with much higher global coal output and the decline in steel, and you have a very nasty situation for key Australian exports. In the case of gas the Russians have signed a deal with China to export a quantity of gas equal to the entire Australian production at a price that is clearly lower than Australian prices. And Russia has the capacity to almost double the output at a lower marginal cost. That has sent gas analysts into a frenzy, and some are suggesting that the Russian deal will simply lower the price of longer-term Australian gas. And while the Australian gas contracts cover extended periods and protect our producers, it is not sustainable to be selling gas above the market for extended periods. Most Australian gas contract prices are linked to oil, so if there is a big variation in the oil price it will affect revenues. (On that basis, Iraq is good news).

China critical to gas sector

At the same time, higher Australian construction costs make it very difficult for additional gas deals to be launched into the market. In the case of gas, the CEO of Santos, David Knox, has a different view to the analysts and says that China’s replacement of coal by gas to reduce carbon and pollution is going to accelerate. And so, China’s gas demand will rise strongly and not only absorb the Russian contract but leave scope for additional Australian contracts.
Graph for When the yield game ends

China will be anxious for Australian gas supply so that it is not too dependent on Russia. And the events in the Middle East increase our attraction. The difference between the two views concentrates on what gas the demand growth rate from China achieves. If Knox is wrong, and the analysts are right, then his major investment in Curtis Island only has token value and the major investment of Santos becomes the Cooper Basin.

It is very important for Australia that Knox is right, because we are going to need the gas revenue to support our tax revenues in light of the decline in minerals investment and the tougher times for iron ore and coal. My guess is that the Chinese are going to work very hard in the next year or two to translate the lower Russian gas price into a working price for the new gas contracts, which will make it very hard for Australia – although Knox says construction costs are falling by between 20% and 30% now that sanity has returned to the industry as the construction boom subsides.

All these factors are going to affect our dollar when the interest rate game has run its course. I don’t know when that could be, and these things usually take longer than we think. We so we are talking about a longer-term strategic play, but you can stagger your US exposure over an extended time in recognition that you never can read the bottom of a market.

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