Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

October 10th, 2010

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Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

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  • Pete

    Another great article CIJ

    All of this currency exchange stuff completely confuses me. There are so many relative values at play, that will dynamically change depending on other changes in global trade, that to predict the knock-on effects becomes ever more complex.

    So much of the commentary that I read on the internet is US based. I am fairly clear on what will happen to the US over time, but the impact on the global economy remains ever more illusive. Eg, what happens to Australia if the USD falls?

    Could Australia have hyperinflation? Under what circumstances? Which currency would we use instead of our own plastic money? As an island we don’t have the luxury of neighbouring countries with stable currency. Chinese Yuan springs to mind first.

    I am convincing myself more and more that all of this cheap cash that will be floating around as the USD and other currencies print money to devalue their currencies, that one of the things that will be bought/consumed the most will be oil/energy.

    Stimulus requires minerals, but also energy. I see a huge energy crisis over the horizon. Especially if someone is silly enough to push the war thing.

  • Pete

    Another great article CIJ

    All of this currency exchange stuff completely confuses me. There are so many relative values at play, that will dynamically change depending on other changes in global trade, that to predict the knock-on effects becomes ever more complex.

    So much of the commentary that I read on the internet is US based. I am fairly clear on what will happen to the US over time, but the impact on the global economy remains ever more illusive. Eg, what happens to Australia if the USD falls?

    Could Australia have hyperinflation? Under what circumstances? Which currency would we use instead of our own plastic money? As an island we don’t have the luxury of neighbouring countries with stable currency. Chinese Yuan springs to mind first.

    I am convincing myself more and more that all of this cheap cash that will be floating around as the USD and other currencies print money to devalue their currencies, that one of the things that will be bought/consumed the most will be oil/energy.

    Stimulus requires minerals, but also energy. I see a huge energy crisis over the horizon. Especially if someone is silly enough to push the war thing.

  • All these currency volatility seems to attract more and more people into forex trading as dead bodies attract more and more flies. Now we are seeing more and more forex trading products that employs massive leverage. Perhaps in 5 years time, the conversations at the barbie wouldn’t be property investing any more? Instead people will be talking about their forex trading exploits.

    If governments insist in printing money and setting interest rates below the rate of price inflation, they are in effect forcing more and more people to speculate.

  • Ted

    CIJ, while the masses play the game of musical chairs (speculate) which they are sure to lose, the money of those with eyes to see will surely be in Aurum, no?

  • It’s called financial repression and in my opinion it won’t end well. I just wish I was cleverer financially. I understand what is going on but I’m buggered if I can figure out a reliable way to protect and grow my own assets. I make too many dumb mistakes.

  • Hey, nice article. I couldnt agree more. Expectations of a second round of quantitative easing plus the Feds POMO scheme is certainly propping up equities and the AUD. How long can it go on for? I tend to think QE2 is priced in, should Benny boy disappoint on November 3rd, we could be in for a sell-off. I recently posted something on this very same topic:

    http://www.bullionmark.com.au/gold-research/blog/2010/10/00/107-Strong-Aussie-Dollar–A-Golden-Opportunity.html

  • russell cullen

    Kick out the Gillard labour Goverment and devalue the Aussie by 25 cents.RUSTY