Why the Reserve Bank of Australia are in denial

Over the past two RBA monetary policy meetings, the minutes released have revealed a somewhat positive outlook on the housing market. The minutes for the September 3rd meeting reiterated the view that the housing sector has continued to show signs of development. It also outlined that low interest rates have contributed to the improvement in the housing sector.

What is worrying here is the fact that the central bank has failed to identify how this could contribute to another boom-bust housing cycle. Australian homes are already regarded as overvalued, and as the mining boom cools, it is easy for the central bank to become more reliant on the housing sector as a source of growth. The recent uptrend in housing figures from Australia has confirmed this, and with household debt currently at 150% of GDP the Australian housing market is definitely something to monitor.

Even the Aussie’s neighbours have taken steps. The central bank of New Zealand have already acknowledged the potential risk to their economy and have put in place macro prudential policies, such as loan to value ratio restrictions, in order to curb housing related credit growth and price pressure. RBNZ Governor Wheeler outlined that this would help better position banks in the event of shocks, limiting damage to the housing sector and the economy.

The chart below shows the world’s most overvalued economies, with Australia not too far behind New Zealand.

Source: OECD

Chart 2 allows us to analyse the effects of the base rate against house prices more closely. From this we can see that when interest rates were higher, house prices rose more steadily, such as the period from 2005 through to March 2008. As the global crisis took hold in 2008 house prices plummeted and rates were lowered in order to support the economy. The lower rate then fuelled a sharp acceleration in house prices which tumbled shortly after, highlighting the significance of lower interest rates to house prices. The problem is the RBA fails to recognise that the effects of record low interest rates are already being seen. If the central bank needs to cut rates further to support economic growth, we could potentially see the housing market spiral out of control. In addition, the RBA has stated that a weaker Aussie will help the recovery, but a weak Aussie, coupled with high household debt that is likely to increase if rates are cut further, can easily create turmoil in the housing market and vulnerability to shocks.

RBA Asst Gov Malcolm Edey has said we should not rush into a bubble analogy, but surely recognition and consideration of the potential longer-term effects, of an already overvalued housing market is not too much to ask? Especially considering we have witnessed the repercussions when such signals are ignored.

Sasha Nugent

Currency Analyst

Caxton FX 

September 2013 Monthly Report: UK recovery moves from strength to strength

July was certainly a better month for sterling, taking advantage of struggling commodity currencies such as the aussie and kiwi. This was a result of a number of factors including better than expected data releases. The release of the BoE Inflation Report revealed forward guidance explaining that the outlook of interest rates will be linked to unemployment and inflation and that when ‘knock out’ conditions are breached, the monetary policy committee will have reconsider their stance on interest rates. Meanwhile the BoE minutes showed that MPC member Martin Weale voted against forward guidance because of the risk of rising inflation breaching the main goal of price stability. Upward revisions to the UK GDP reading has worked in the pound’s favour as well as strong PMI data also supporting the pounds uptrend.

The dollar on the other hand has begun to regain ground against major counterparts and the case of QE3 tapering rambles on. With September now underway, tension continues to build as to whether economic fundamentals provide enough reason for the Fed to reduce stimulus as soon as this month. Some economic releases such as Preliminary UoM consumer sentiment and new home sales did prove to be disappointing while housing data signals that unemployment is heading in the right direction. Nevertheless, the overall perception of the US economy remains fairly positive and speculation on whether the Fed will announce the beginning of tapering on September 18 remains.

The euro has been the bright spark recently with economic fundamentals surpassing expectations and boosting the views that maybe the eurozone recession is bottoming out. GDP figures have shown Q2 growth for the euroarea which has boosted investor confidence and encouraged EUR strength. Figures out of Germany have also favoured the euro and are becoming more and more like the glue holding the eurozone together. There is still plenty of worrying news out of the Euro area including high unemployment and the Greek funding gap issues which may present themselves as an increasing concern.


GBP/EUR

The UK economy is beginning to look much more stable than previously thought and the positive stream of UK data has worked in the pounds favour broadly speaking. The release of the Inflation Report and Bank of England policy meeting minutes provided the market with some clarity through forward guidance, which aimed to outline the direction of future interest rates.

The month of August saw the UK Service PMI figure jump to 60.2 and both manufacturing and industrial production exceeded estimates at 1.9%m/m and 1.1%m/m respectively. The good news continued through the month as the trade deficit narrowed to £8.1bn and inflation slowed to 2.8%. The upward revision to the Q2 GDP reading confirmed that recent positive stream of data was being reflected in improved UK output. Second quarter GDP was revised up to 0.7%qoq. The Confederation of British Industry raised their forecasts for expected GDP growth this year further supporting the view that the UK recovery is strengthening. CBI Industrial order expectations smashed predictions signalling businesses are more confident about the progress of the economy and are subsequently acting on it. Although the 0 figure doesn’t exactly scream an increasing order volume, it doesn’t signal a reduction in order volume either, and is therefore a step in the right direction.

The Bank of England Governor Mark Carney outlined in the Inflation Report that future interest rates will remain low until unemployment is at 7% which is expected in 2016. Initially this was taken pretty well by the market as it simply outlined what the market expected. However as UK data continued to impress, the likelihood that the unemployment rate will fall to 7% before the 2016 estimate increased resulting in upward pressure on the interest rate. The monetary policy meeting minutes revealed that committee member Martin Weale was against forward guidance on worries about the effect on inflation, proposing that a shorter timeline for considering rates would ensure price stability. This fuelled doubt about whether the Governor can actually ensure rates will remain at 0.5% with yields pushing higher, potentially threatening the recovery. In Carney’s first speech, the aim was to convince the market that he would be able to keep rates low until 2016 as expressed through forward guidance. This was partly successful in the sense that he reiterated the committee’s commitment to sustainable UK growth, revealing that the BoE may provide extra stimulus if the UK recovery is being threatened by rising market rates. On the other hand, with gilt yields rising on the back of his comments, it can be argued that he didn’t manage to achieve the objective of combat higher market rates. Investors seem to still believe that with the way the economy is going, a rate hike may be seen sooner and with inflation still well above the target at 2.8% it is understandable why.


The euro begins to get back on its feet

Better Eurozone fundamentals have seen the euro take control of this pair towards the end of last month, while good economic figures from the UK have been overshadowed. The first important signal came from Italy when its preliminary GDP reading showed the recession eased, contracting 0.2% q/q. Other fundamentals such as German, French and Eurozone GDP figures beat expectations, promoting confidence in the Euro area. PMI figures for Germany and the Eurozone were received well despite a disappointing figure from France.

Other German data releases such as the German IFO data and German ZEW Economic Sentiment came in above expectations boosting perceptions about the state of the German recovery and ultimately euro zone progress. Encouraging releases have fuelled suggestions that the positive movement in the EUR has been a result of German figures rather than an overall improvement in the region.

Problems in the Eurozone are persistent especially in Greece. It was revealed that the country will need another bailout after its current package is due to expire next year. The IMF has put the combined figure needed for Greece at €11.1bn for 2014 and 2015. Unemployment remains an issue throughout the eurozone, with Greek unemployment hitting 27.6% and the IMF sending Spain a warning about their unemployment rate currently at 26.3%. Imbalances within the area are evident as the German manufacturing and service sectors expanded while the French contracted.

After broadly trending upwards for most of August, we are likely to see the GBPEUR trend repeat itself next month. Despite the Eurozone showing sparks of improvement, the overall outlook for the UK is outpacing that of the eurozone. This week sees monetary policy announcements from both the BoE and ECB and although no rate changes are expected, the market will be drawn to the central banks’ comments on the state of both economies. We expect the GBPEUR rate to improve gradually from its current levels even though a dovish Carney and over optimistic euro investors could limit sterling gains.


GBP/USD 

Speculation on Fed tapering rambles on

During August there has been a considerable amount of evidence supporting the Fed case for reducing its asset purchasing program. Data has been mostly positive indicating that US growth is stable and the economy is picking up pace.

A number of Fed members have made statements claiming that the Fed’s decision to reduce stimulus will be dependent on the outlook of the US economy. As a result, investors have been eyeballing US data looking for signs on the strength of the recovery. Better than expected data releases such as ISM- non manufacturing PMI data and core retail sales have steered the market into predicting a reduction in stimulus. There has been some disappointing figures such as Preliminary UoM consumer sentiment as well as new home sales which provided doubts as to whether it is wise for the Fed to take their foot off the stimulus pedal however, data still suggest there are enough positive signals to assume tapering will take place this year.

Preliminary GDP figures which showed US output accelerated by 2.5% (consensus of 2.2%) simply brightened the US outlook and has triggered some dollar movement to the upside. Considering speculation has been on-going, the GBPUSD rate has been fairly resistant gradually rising through the most of August. As the case for tapering continues to build, we have begun to see a reversal, with the month end showing the beginning of a downward trend.

Whilst we expect data to continue to fan the tapering flame towards the end of this year, the market will be looking forward to the Fed rate announcement on September the 18th, which will indicate clearly whether we can expect tapering to begin as soon as this month. The possibility remains that the central bank may hold off this month, as a result of the mixed messages sent by recent data releases. Nevertheless, the fact remains that dependent on the outcome of economic fundamentals, tapering is still very much a possibility as we approach year end. Mixed data releases may prompt the Fed reduce stimulus at a slower rate ranging between $5bn- $10bn until the recovery becomes self sustainable. Good releases from the UK and optimism about the outlook will attempt to prevent the dollar rising, yet with the effects of possible tapering and a dovish Carney, it is unlikely that the pound will be able to withstand dollar gains, in spite of recent upward movement. Therefore we believe the downwards trend we have witnessed of late will continue though the month.

GBP/EUR: €1.18

GBP/USD: $1.54

EUR/USD: $1.31

Sasha Nugent

Currency Analyst

Caxton FX 

German confidence tumbles again, pointing to possible German recession

A monthly German survey, which covers around seven thousand firms, has been released this morning to reveal that German business confidence has declined for the fifth consecutive month. A flat reading was expected but German business confidence has now dipped to its weakest level seen since March 2010. The news provides further evidence of the dampening effects of the eurozone debt crisis on the region’s powerhouse economy and has accordingly weighed on the single currency today.

Firms in manufacturing, construction, trade and industry were mostly responsible for the poor climate reading, though retail and wholesale trade did improve slightly. The regional downturn is having a particularly noticeable impact on Germany’s exports to other eurozone nations. The economic weakness being seen in major nations like Spain, Italy and even France cannot be viewed in isolation; recessions are particularly contagious in a currency union like the eurozone and this morning’s data indicates that Germany is succumbing.

Interestingly though, an economist from the producers of the data - the Institute for Economic Research - has stated that German consumption remains robust despite a weaker labour market and therefore does not see a need for an interest rate cut from the European Central Bank. An interest rate cut would however weaken the euro, which could boost exports outside the eurozone, though this would require Germany’s preoccupation with high inflation to be set aside. The IFO economist did also note that the survey was taken prior to the positive decision from the German Constitutional Court earlier this month, the uncertainty surrounding which may be at least partly responsible for the unexpected decline.

The economic downturn is not just bad news for Germany but for the eurozone’s peripheral nations as well. If Germany enters recession, then it is going to be increasingly difficult for Merkel to justify and deliver the support she is pledging for struggling nations like Spain and Italy. With plenty more austerity measures still to come across the eurozone, the prospects for the economy as a whole and Germany by association, are rather gloomy. After Q2’s 0.3% GDP growth, Germany may avoid economic contraction in Q3 but the same is unlikely to be true in Q4, such is the downtrend that is in place. This is not to say that Germany is certain to enter a recession but the risks are very significant and it is looking increasingly likely, which is bad news for all concerned.

We may have seen some progress on the debt crisis in the last month or so but economically, the region is in very poor shape indeed, which is in part why we maintain a negative outlook for the euro.

Richard Driver

Currency Analyst

Caxton FX

The aussie dollar is flying high but where does it go from here?

Australian dollar has gained by over 6.5% over the pound in the past two months, strengthened by nearly 7.5% against the USD in the past six weeks, and hit fresh record highs against the euro only this afternoon. The Reserve Bank of Australia cut its interest rate to 3.50% in early June and its key trading partner China continues to slowdown, so what is driving this latest rally in the aussie dollar?

One major factor fuelling the current positivity towards the AUD is the development that the German central bank, the Bundesbank, is set expand its portfolio of Australian assets. The eurozone crisis has caused central banks all over the world to review their reserve allocations and among others who are set to invest in Australian assets is the Czech central bank. This factor has completely overshadowed any dampening effects you might have expected as a result of the collapse of risk appetite that saw many higher-yielding currencies and equities decline since early May.

In addition, Australian economic data has in general held up remarkably well given the decline being seen in the Chinese economy (Chinese GDP has slowed down from a pace of 9.5% to 7.6% in the past year). Recent data revealed that Australian GDP expanded by an impressive 1.3% in Q1 of this year, well up from Q4 2011’s figure of 0.6%. This domestic economic strength gave the Reserve Bank of Australia the confidence not to cut its interest rate again in July.

However, we are seeing considerable risks of a rate cut in August as this domestic performance looks unlikely to persist. Recent Australian data has taken a downturn, particularly in terms of the domestic labour market. As well as July’s weak labour numbers, forward-looking indicators point to further softness.

Importantly, data revealed a sharp drop in Chinese imports from Australia in June and weekly New South Wales coal shipments have also fallen off this month. Equally, Chinese steel production has declined and its iron ore inventories have climbed, suggesting waning demand for aussie exports in the months ahead. As well as further deterioration in Chinese growth, we take a gloomy view as to the outlook for global growth and financial conditions, driven not least by eurozone risks. If a rate cut doesn’t come in August, we would be very surprised if it didn’t come in September.

For these domestic and international reasons, we see the AUD rally halting soon. AUD/USD should fail to sustain any breach of 1.05 and we should see this rate head back down toward and below parity in the coming months. In terms of GBP/AUD, downside scope is looking increasingly limited. The aussie is deep in overbought territory and we expect 1.55 will be seen once again before long. In addition, when the aussie dollar does endure its downward correction, it could well be quite a brutal move.

Richard Driver
Analyst – Caxton FX
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Swedish Krona March Outlook

The Swedish krona and other risky currencies finished 2011 strongly and made an impressive start to 2012. Risk appetite has been spurred on by the ongoing impact of the European Central Bank’s (ECB) mid-December LTRO (cheap loan offering), further improvements to the US economic recovery and the emergence of a Greek bailout agreement.

However, huge uncertainties surround both the Greek and wider eurozone debt situation. In addition, data this year clearly points to the onset of a recession in the euro-area. The risks to a downturn in market sentiment, which will inevitably weigh on the krona, are all too apparent.

In terms of the Swedish economy, growth has deteriorated and the prospects for this year have weakened. Amid diminishing internal and external demand and rising unemployment, the Swedish economy contracted by 1.1% in the final quarter of 2012. Accordingly, the Riksbank is forecasting growth of just 0.7% for 2012.

The Riksbank cut the Swedish interest rate by 25 basis points to 1.50% in February, following the rate cut we saw in December. Further monetary easing this year cannot be discounted if conditions continue to worsen. In addition, after an impressive surplus last year, the Swedish National Debt Office has recently announced that it expects a budget deficit of 11bn krona this year.

We hold a pessimistic view for Greek and eurozone developments this year, on both the growth and the debt front. This should weigh on risk appetite and combined with the Swedish economy’s downtrend, the outlook for the Swedish krona is decidedly vulnerable.

GBP/SEK

Interest rate developments have gone against the Swedish krona in recent months, with the Riskbank reducing its yield from 2.00% to 1.50%. The moves were down to both diminishing global and domestic growth. With the eurozone accounting for more than half of Swedish exports, the recession that the region is heading into is likely to weaken Swedish growth to an even greater degree. The Swedish inflation outlook is also distinctly tame, so there is little scope for a Riksbank rate hike this year, while a further cut will certainly be considered if conditions both internally and externally deteriorate.  

This Swedish downturn contrasts with the good news that has emanated from the UK economy in the past few weeks. UK retail sales figures have been excellent; the services sector continues to show decent growth and the construction sector also bounced back in February. These firmer figures have made a return to positive growth (after last quarter’s -0.2% GDP figure) highly likely in Q1 2012. This in turn should dissuade the MPC from deciding on further UK quantitative easing this year. It also increases the likelihood of the UK hanging onto its prized AAA credit rating, which is a major pillar of support for sterling.

The ECB’s cheap loans have fuelled a rally in risky assets in the past three months, as shown by the FTSE 100’s recent climb to a seven month high. However, an improved outlook for the UK economy (and therefore sterling), a deteriorating Swedish economy and a fairly sharp decline in risk appetite have seen GBP/SEK show signs of resuming last year’s uptrend. In line with a pessimistic view towards the overall eurozone situation, we see GBP/SEK consolidating on its recent bounce in the 10.7-10.8 area over the next few weeks. In the medium and longer-term, the risks are skewed towards a further upside move towards 11.00.

EUR/SEK

There have been some positive developments in the eurozone in recent months. The ECB’s cheap loans have ensured that credit conditions in Europe have eased this year and have fuelled a rally in eurozone equities and brought key peripheral bond yields in Italy and Spain down to more sustainable levels. A long-awaited Greek bailout agreement finally arrived in February, quelling fears of a messy Greek default in mid-March (albeit temporarily).

However, the market also remains incredibly tense about the Greek situation. A Greek bailout is by no means assured, which means we may yet see a messy Greek default this month. Greece has until the evening of Thursday 8^th March to convince enough private bondholders to sign up to the debt-swap arrangement, failure to do so could result in a credit event in which credit default swaps are triggered.

The potential Greek scenarios that are currently on the table are many and varied and this lack of certainty is what is weighing on risk appetite at present. Even in a best case scenario in which Greece gets its second bailout and avoids a default without triggering a credit event, there are strong arguments that suggest this is simply an exercise in buying time and we could be back in bailout and default territory before long.

In addition, eurozone growth remains a key concern. The region contracted by 0.3% in the fourth quarter of 2011 and judging by growth figures out of Germany and the region as a whole, a slide back into a prolonged recession is now looking somewhat inevitable.

By virtue of the Swedish krona’s negative correlation with low levels of risk appetite and in line with our view that we are entering a period of damper market confidence in which safer assets than the krona will be turned to, we are confident that EUR/SEK will continue to climb. We have seen a sharp spike from 8.80 to over 8.90 in the past week and we are looking for a push towards 9.00 in March.

USD/SEK

To buck the global trend of weakening global growth, the US recovery has really gathered pace in recent months. The US economy grew at an impressive annualised pace of 3.0% in the fourth quarter of last year and there have been significant improvements to America’s chronic unemployment problem. This upturn seems to have caused US Federal Reserve Chairman (Ben Bernanke) to indicate that QE3 will not be utilised, which is a real positive for the US dollar.

By contrast, the US dollar made a very weak start to 2012 but we believe the greenback will be a major outperformer this year. With intervention doubts surrounding the other traditional safe-haven currencies (the yen and the swiss franc) and with the EUR/USD pairing looking increasingly vulnerable to a collapse, the USD is set for major gains in what will surely be a highly uncertain, dollar-friendly environment this year.

The bounce in the USD/SEK rate (from 6.55 to 6.80) in the past week should represent the start of a major reversal of dollar weakness. We see the USD strengthening in excess of 7.00 krona level in coming months, though over the next few weeks gains will probably be limited by the 6.90 level.  

NOK/SEK

The Norwegian krone has made an extremely impressive start to 2012. It is the top performing currency over the past month thanks to a combination of domestic economic strength and soaring oil prices.  Norwegian manufacturing and retail sector growth and declining unemployment has improved sentiment towards the NOK, while a widening trade surplus shows that exports are not being hit as they are in neighbouring Sweden.  The Norwegian economy outperformed the Swedish economy in the fourth quarter of 2011 by growing 0.6% (versus Sweden’s 1.1% contraction) and is almost certain to continue outshining this year.

Oil prices have risen by 15% already in 2012 amid worrying developments in Iran; Brent crude is currently trading just off a multi-month high above $125 per barrel.  As a major producer of oil, the Norwegian economy stands to benefit and so too does its currency.

The only real question mark hanging over the Norwegian krone is the monetary policy of the Norges Bank. The state of Norwegian economic growth wouldn’t suggest another cut to the Norwegian base rate, which currently stands at 1.75% (slightly higher than the Swedish 1.50% rate). However, Governor Olsen has reiterated that the Norges Bank will consider the strength of the krone when evaluating its interest rate policy. Another rate cut may well come if the NOK continues to appreciate but the krone is likely to remain in demand regardless.

With the NOK/SEK rate having bounced from just above 1.14 to just below 1.20, the Norwegian krone is the clear outperformer here. NOK/SEK is actually trading only marginally below a 25-month high. However, the current pace of appreciation is unlikely to persist for another month as Norges Bank intervention concerns will inevitably temper progress. Still, we should not see too much of a downward correction away from the current 1.20 trading level.

Conflict within the fed - what can we take from it all?

Monetary policy is incredibly loose in the US. Record-low interest rates paired with a second round of quantitative easing, have made the dollar a far less appealing prospect to investors. Now, in the past few sessions, noises coming out of the US central bank have started to change.

Several Federal Reserve policymakers have recently given indications that the Fed's second round of quantitative easing (QE2) will end in June. Some have hinted that QE2 could even be cut short before its scheduled June end-date, whilst others have remained coy – stating that they will assess economic conditions and the suitability of the policy closer to the time.

To clear up any confusion, US policymakers have all voted unanimously to maintain QE2 due to a convention of solidarity within the Fed. However, there are quite clearly differing opinions within the group. This contrasts with the situation in the BoE where we currently have a 6:3 split in favour of those voting to keep interest rates unchanged.

The dollar has underperformed all year; largely due to this loose monetary policy approach from the Fed. However, hawkish comments have boosted the greenback in recent sessions, pulling it up from multi-month lows against both the pound and the euro. So what are the long-term implications of this shift in rhetoric? Well, the US economy is looking in a significantly stronger positions than that of the eurozone and the UK. But crucially, the markets are not so interested in economic fundamentals at present; rather they remain focused on prospect interest rate differentials. .

Whilst comments made about curtailing QE2 have been dollar positive, the Fed has made no indications that it will raise rates this year. We can therefore only assume that it intends to tighten policy in early 2012. By contrast, both the ECB and the BoE are expected to raise their base interest rate twice - or even three times - in 2011, and for this reason we can only see the dollar underperforming, holding on to its steady downtrend over at least the medium term.

Richard Driver
Analyst – Caxton FX
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Dollar weakness, but for how long?

The start of 2011 has seen the US dollar loosen its stranglehold over both the pound and the euro. Both currencies are continuing to rally strongly in spite of the fragile economic conditions still seen within both camps.

We have seen gains for the Euro and the pound of around 3% and 4% respectively since the beginning of this year, but how long can this dollar weakness last?

The main driving force behind the movement has been the diverging policy stance seen between the Fed and its counterparts across the Pond.  

The Fed has reiterated its desire to keep interest rates low for an “extended period”, alluding to the fact that, despite some decent economic growth (2.9% in 2010), it will continue to keep monetary policy loose in order to stimulate growth and absorb the chronic levels of unemployment.

By contrast there is speculation that both the ECB and BoE could move to tighten policy (ie raise interest rates) in order to curb inflationary pressures. Such a move is still seen to be some months away, but would doubtless come considerably earlier than in the US, which is bolstering the currencies.

Earlier today, one of the two MPC hawks, Andrew Sentance, suggested that the Bank should act sooner rather than later to retain the Banks' “hard won” credibility by keeping inflation in check, and avoid a sudden and heavier rise of interest rates down the line that would “jolt” the recovery. This policy is beginning to gain further credence, with Sentance sticking to his guns despite recent worries of stagflation.

Similarly, Trichet has recently been hawkish about the prospects of raising interest rates – the market expecting this to come in to effect around September, probably as part of his swansong (his term as ECB President is due to end in October).

With this in mind, coupled with the headlines being oddly devoid of any developments with regards to the eurozone debt crisis, it’s hard to see the dollar reversing its current trend in the short term.

Edward Knox
Analyst
Caxton FX

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