Will the RBA be dragged into the new currency wars?
This week we’ll learn whether the United States Federal Reserve is prepared to fight another round of the global currency wars and, by consequence, whether the Reserve Bank of Australia will be dragged kicking and screaming into this war later this year.
The Fed meets this Tuesday and Wednesday for the second time this year. It’s also only one of four Fed meetings this year in which the Fed unveils a new set of economic forecasts, including its now famous “dot plot” indicating where voting Fed members each see official interest rates going over the coming few years.
Recall that back in December (the last time the Fed issued economic forecasts), all Fed members expected the Fed funds rate to at least rise to the range of 0.75% to 1% by end-2016, implying at least two further quarter point rate rises this year. The median forecast among Fed members was for a rise of the funds rate into the 1.25-1.5% range, implying four quarter point rate rises this year.
With the upsurge in market volatility in January and early February – and a smattering of weaker economic reports - markets became confident the Fed would dutifully jettison its rate rise agenda.
But guess what: US economic data and Wall Street have subsequently rebounded, and there now seems very little reason why the Fed should change its mind.
Indeed, I suspect Fed chairperson Janet Yellen had, back in December, already tentatively pencilled in a likely follow-up rate this week. Rest assured: it won’t happen, but recent market volatility has put paid to that. But the case for US rates rises remains strong.
Having given up on a March rate rise, chances are that the Fed will scale back its rate rise intentions – with a median forecast of three rate rises this year, taking the range for the Fed funds rate to 1-1.25%. It is very unlikely the Fed will accede to market hopes and completely ditch the expectation of higher rates this year.
If the Fed stays the course, and hints this week at several more US official interest rates this year, it should help to strength the US dollar and weaken the Australian dollar. Indeed, like Australia, many countries around the world are relying on currency weakness – largely against the US dollar – to help support their economies.
Of course, for the Fed the question is whether the underlying momentum in the US economy is really strong enough to support further currency strength. Given the US dollar is a market determined price, I have a relatively simple way of looking at this: either the US can support a stronger currency or it can’t.
If it can’t, it won’t and the US dollar won’t rise.
After all, to the extent an unduly strong US dollar hurts the US manufacturing sector and exports – such that the overall economy is seriously damaged – it would be a signal to the deflation-fearing Federal Reserve to halt further interest rate increases, and potentially even reverse course though a new round of quantitative easing. We got a glimpse of this potential scenario in February.
Under this scenario the $A would remain strong and likely force the RBA into joining the currency war with lower local interest rates.
But if the US economy keeps chugging along this year even as the US dollar firms, then the Fed can keep on course.
What’s the likely outcome? To my mind the US economy can support a stronger US dollar – indeed, it’s probably one of the few economies in the world that can currently live with a stronger exchange rate.
For starters, as a large country with large internal markets, exports are relatively less important for the United States, accounting for only 12% of GDP (compared to around 20% in Australia). And unlike in Europe and Japan, the US is better able to rely on robust population growth and domestic demand to support growth – indeed, consumer spending, housing and business investment have been important mainstays of the economy.
Low interest rates, robust employment growth and low oil prices should continue to support the US consumer. And even though the shale oil sector is in retreat, US business investment more broadly also remains firm. Home building is still at a below-average level and can and should rise further.
That suggests the base case scenario this year should continue to be higher US interest rates and firmer US dollar. In turn, that should help lower the $A and limit the upside to commodity prices. I’m still doubtful, however, that resilience in the US economy will avoid downward pressure on corporate earnings (due to rising wages, weaker offshore earnings and already high profit margins) which will be especially challenging for Wall Street.
Of course, that’s why Wall Street is hoping and pleading it does not also have to contend with higher US interest rates – but that seems to be hoping for too much.
Note, moreover, that should the US dollar rise, it will place further pressure on China to devalue against the greenback – lest the overall Chinese real exchange rate index rise even further into the stratosphere. As should be evident from the chart below, if anyone is losing the currency wars at present, it’s China – which is another reason why its industrial sector is ailing so badly
China has pledged to keep its currency “stable” this year. It’s a big ask.
If China responds with a large shot across the bows – such as a large one-off devaluation - it would be yet another challenge for global markets to digest this year.
Published: Monday, March 14, 2016