FYI | Jul 29 2008
By Chris Shaw
Since the credit crisis first emerged the US Federal Reserve has been doing what it can to support the US financial system and its financial institutions in particular by market-stabilising actions such as purchasing debt from Fannie May and Freddie Mac and a steepending in the yield curve, but nothing similar has been done in the Australian financial sector by the Reserve Bank of Australia (RBA).
As GaveKal notes the reason there has been no similar action in Australia is the strength of the commodities cycle has kept the resources side of the economy strong and this in turn has kept inflationary pressures high. This is limiting the RBA’s possible policy responses, particularly with respect to the downturn in the housing sector.
But the recent rolling over of commodity prices may in fact give the RBA the breathing room it needs to cut rates, which GaveKal sees as having significant implications for the Australian dollar. As the group points out, Australia has been a favoured destination of those investors involved in the carry trade given the yield differential on offer between Australia and Japan.
The extent of the attraction of Australia’s interest rates is evidenced by the fact Daiwa Asset Management is now reported to own around 4% of the Australian government bonds in the marketplace, making it the single largest holder of such securities.
The fact the Japanese have been so enthusiastic about investing in Australian dollar denominated assets creates a potential problem for the Aussie curency as in GaveKal’s view if the Australian dollar/Japanese yen carry trade becomes less attractive the Japanese are likely to switch attention to their domestic equities market given it offers selective opportunities for attractive earnings yields and is supported by an undervalued currency.
If this does happen and Japanese money starts to flow out of the Aussie dollar and back into yen GaveKal suggests it will put the Aussie dollar under pressure as any fall in the level of buying of Australian dollar denominated securities would be a negative for the currency given the need for inflows to support Australia’s current account deficit.
On the group’s numbers this deficit has growth from 2% of GDP six years ago to around 7% now despite the benefits of the commodities boom, so any fall in the level of fund flows would potentially set up a significant fall for the Australian dollar in GaveKal’s view.
