Australia’s Not Spain

Down Under the problems remain
(Though nothing at all like in Spain)
Investment is falling
So Stevens is calling
For rate cuts to limit the pain

As I scan the FX markets this morning two currencies jump out as interesting, AUD and INR, and the rest have much less to recommend. The G3 currencies are essentially unchanged and most other currencies have seen only limited movement. So let’s talk AUD. Last night, RBA governor Glenn Stevens made a speech where he intimated that as the mining investment boom of the past 3 years wanes, nothing else has picked up the slack. He also noted that inflation was well below target and that the RBA’s previously mentioned scope for further interest rate cuts was likely to be utilized. In other words, look for the RBA to cut at least 25 bps next Monday night, and I would now put a modest probability on a 50bp cut. Market reaction was predictable and immediate with Aussie falling one cent almost instantly and then grinding lower from there. At this point, AUD is less than 1% away from its 3-year lows at 0.8999, but as I have written before, I feel it is just a matter of time before that level is breeched and we head toward the longer term average near 0.80. The combination of further RBA easing and potential Fed tightening (we will get back to this in a moment) will be too much for the AUD to withstand.

As to INR, the decline was pretty steady throughout the overnight session as the market responded to comments by the RBI’s Governor, Duvvuri Subbarao. Last night he was talking about many things, including the Rupee, which he claims the RBI will be able to manage effectively, at least with respect to mitigating volatility. Of course, last night’s 1.7% decline may call that ability into question, but given the ongoing issues in India, with a growing C/A deficit, slowing growth and rising inflation, it will take all the central bank’s skills to keep the currency from tumbling. Frankly, though I have been sanguine about the problems in India in the past, I am losing faith in their ability to manage things at this point. Given the overall slowdown in global growth and the policy paralysis that continues to exist in India it is difficult to be overly optimistic about the currency. I think the RBI will do all it can to mitigate the decline, but at this point, I have come to believe that the INR has further to fall. Could we reach 65? I think the answer is yes.

Now back to the idea about potential Fed tightening. As we all know, this morning the FOMC begins a two-day meeting with the next policy statement to be released tomorrow afternoon at 2:15pm. The Fed is not going to change policy in any way tomorrow, of that I am certain. But the nuances of what they are doing are worth discussing. University of Oregon Professor Tim Duy has made a very interesting observation about the Fed’s policies. ( Right now, policy consists of zero interest rates, QE and forward guidance, each designed to add to easy money. However, there is a growing concern, both inside and outside the Fed, that QE may have reached the end of its usefulness. As I have written, along with many others, unwinding QE will be a very big issue with significant ramifications in the market including increased volatility and likely sharp declines in asset prices. Professor Duy’s observation is that it seems that Bernanke is trying to alter the mix of policies while keeping the same total amount of monetary easiness in place. So the talk of tapering asset purchases is to be taken hand-in-hand with additional forward guidance. In this way, he can start to remove the policy piece that is getting out of hand, while still supporting the market as aggressively as he has been doing all along. This would likely take the form of a reduced economic outlook or even more definitive guidance on when rates are likely to rise again based on further information. Remember, the taper was based on the idea of growth increasing toward 3.0%-3.5% next year. If that outlook is moderated, then the market will expect tapering later, although it would be unlikely to see an increase in QE. But it also could be that a diminished outlook for growth simply means that the taper happens and rates stay at zero for even longer. It is worth reading Professor Duy’s piece for the full explanation. It is quite interesting.

So today is shaping up to be fairly dull with only Case/Shiller and Consumer Confidence. Look for limited activity today, but be prepared for tomorrow, as we open with ADP Employment and then get Q2 GDP and the FOMC statement as the day moves on.

Good luck