Since April 2006 to the July 2008, the main narrative for the Aussie dollar is that it was going to reach parity with the US dollar. As you can see from our Market Club chart, during that period of time, the trend of the AUD was up:
USD/AUD trend from October 2004 to October 2009
Back then, short-term interest rates in the US was down while in Australia, it was still going up. Then as the Global Financial Crisis (GFC) struck, Australia’s rising interest rates trend was reversed into a hasty cuts by the RBA. That was the period when the AUD fell precipitously in the context of global deflation. Then in the context of “green shoots,” zero short-term American interest rates and the RBA’s hints of more interest rates hikes to come, the AUD returned to an upward trend again.
In a world of plentiful highly portable hot money, interest rates differential is one of the major drivers of such high volatility between currencies. Twelve months ago, as we described in Another complication in RBA?s interest rate cut,
Now, let?s put yourself in the situation of say, a rich Arab investor with plenty of cash (US dollars). Previously, when Australia?s short-term interest rates were high and rising and the Australian dollar was appreciating, it was pretty good to convert your US dollars into Australian dollars and park your money in an Australian term deposits. The biggest risk for you is that the Australian dollar may depreciate, resulting in a loss as measured in terms of US dollars.
Today, we have a rapidly falling Australian dollar and a RBA signalling its intention to cut interest rates. What will you do? Obviously, you will want to pull out your money from Australia as soon as possible. If the other foreigners are thinking the same, you can expert further downward pressure on the Australian dollar, which will increase the pressure for more foreign money to pull out of Australia. This is going to be a problem for Australia.
Today, the situation is reversed. The very same hypothetical Arab investor is going to pump more of his excess zero yielding US dollars into higher yielding Australian dollars. Not only that, zero yielding US dollars will tempt many money shufflers to borrow money for free in the US to be ‘invested’ in Australia. The RBA’s threats to raise interest rates are sure to tempt even more hot money to flow in. As the AUD rose further, it made this carry yet even more profitable, which further lured in more hot money, which in turned caused the AUD to appreciate even more. Some of these hot money is sure to find its way into the Australian stock markets (instead of the safer high yield cash deposits). The formula looks pretty simple:
- Borrow money for free in the US, courtesy of Ben Bernanke.
- Buy AUD to be ‘invested’ in Australia (i.e. short the US dollar).
- If you are more risk adverse, put the AUD into government guaranteed term deposits, courtesy of the Australian tax-payers.
- If you enjoy risk taking, punt on the Australian stock exchange and/or capital raisings.
- Watch you wealth grows as the AUD appreciate and Australian stock prices trend up. With the RBA expected to raise interest rates, watch in glee as your potential returns increases.
- At the first sign of trouble, (1) liquidate your Australian stocks and pull out all your government guaranteed term deposits immediately, (2) sell the AUD to buy back the USD, (3) repay the free money borrowed from Ben Bernanke, (4) pocket your easy profits and (5) retire in Bahamas, thanks to the American and Australian tax-payers.
If you are a small investor, take note of step 6. At first sign of trouble, you can expect the AUD to fall sharply. In fact, judging from the recent tiny rebound in the USD (and fall in the AUD), some of these hot money are already executing point 6.
If this trend reversal becomes entrenched, we can expect tighter credit conditions in Australia (because Australia are net borrowers of foreign money) and the stock market to fall. Then the mainstream media will start to chatter of how ‘confidence’ has fallen in the market. If this chatter continues for an extended period of time (‘justified’ by falling stock prices and AUD), then consumer sentiments will start to follow as credit conditions tightens at the same time. As consumer confidence declines, aggregate spending will decline, which will in turn pull down more economic ‘indicators.’
The Indians will be carrying more firewood soon (see Do sentiments make the economy or the economy makes the sentiments?).
Of course, the Black Swan that can derail this scenario is further government interventions (which in turn will carry more Black Swans of unintended consequences).
