14/08/2012 - 09:15

Analysis: the curse of low rates and the dollar bubble

14/08/2012 - 09:15

Bookmark

Save articles for future reference.

Most people see low interest rates as a blessing. But, hold them close to 0 per cent for long enough and they become a curse, as investors in Europe and the U.S. are discovering, and as Australia will soon discover as a flood of hot money pours into the country chasing our relatively high interest rates.

At some point, and sooner would be better than later, the Reserve Bank of Australia will be forced to stem the tide of foreign cash, either by attempting a form of exchange controls, which is unlikely and generally unworkable, or by the more effective method of cutting local official interest rates.

If the RBA does not act to cut rates, and European and U.S. rates remain at historic lows, then the  cash flood will continue, turning our dollar into a bubble (if it’s not there already), leading to an inevitable currency crash.

Several weeks ago, I predicted the rise of the dollar to parity with the Euro in two years and the British pound within five years, a forecast which remains valid – but mainly because of those currencies collapsing, not so much because of a rapid increase in the value of the Australian dollar.

The problem is that over the past few weeks, the currency has risen too far, too fast, driven by international investors seeking a safe haven, and a reasonable return for their cash. It makes a foreign holiday attractive for Australians, but it damages exporters and is artificially inflating the currency.

The best way of testing the bubble theory is to look at how the dollar has been rising at the same time commodity prices have been falling, taking our terms of trade with them. A rising currency and falling terms of trade are illogical, and will eventually be corrected.

What’s happened to accelerate the rush by foreign investors, of all sizes, into the Australian dollar is the appeal of the country’s relative stability and the lure of interest rates which are not bankrupting the investor.

Consider two examples of what it means to be a saver, or someone close to retirement in Europe or the U.S.

A few years ago, someone with $1 million dollars as a retirement nest egg in the U.S. would have been able to deposit his money and earn between 5 per cent and 7 per cent -- generating between $50,000 and $70,000 a year in interest. Enough to live comfortably.

Today, the same retiree would be lucky to get 1 per cent or 2 per cent on his life savings, and $10,000 to $20,000 a year is not enough to live comfortably.

It’s a similar story for institutional investors who are facing a dramatic deterioration in what they can get investing in corporate and government bonds which have dipped as low of 0.6% on three year money – which is below the inflation rate, which means whoever bought those bonds is actually losing money from day one.

Why anyone would invest confident in the knowledge that he will go broke over time is one of life’s mysteries.

Last week, in the best demonstration yet of investor concern about low interest rates in a region facing a decade of trouble, the world’s biggest oil company, Royal Dutch Shell, quietly shifted $US15 billion in cash out of Europe to safer (higher yielding) destinations.

Shell did not say where the money was going, nor did it admit that it was worried about the safety of its spare cash in depression-hit Europe, but it’s a fair bet that some went into Swiss francs and some into Australia dollars, providing a combination of security and yield.

So long as overseas governments hold interest rates down as a means of encouraging economic activity investors will be forced to consider the risk/reward trade off.

Right now, short-term Australian Government bonds with their yield of 3.3 per cent, or Australian corporate bonds at 6 per cent (and more), are much better than the negative rates on offer at home.

But, if the flow of cash into Australia continues at its current rate the RBA will have no choice but to cut official interest rates to a level that more closely matches our terms of trade, and to help exporters and local manufacturers.

Flattering as it is to have a highly-valued currency it can produce as many problems as artificially low interest rates.

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

Subscription Options