As I’m sure you know, the Reserve Bank of Australia (RBA) surprised the market yesterday with a 0.25 percentage point rate cut. This lowered the bank’s benchmark interest rate from 3.50% to 3.25%.
The reaction? The Australian dollar plunged by more than one cent, and the stock market cheered the news by rallying to its highest level in 14 months.
The media spin is that the RBA rate cut shouldn’t alarm you.
Apparently it doesn’t mean the world is going to hell in a hand basket, it’s just a pre-emptive strike against an expectation that mining investment will peak sometime next year…
While the end of the mining boom may be one of the reasons for the RBA’s action, I also think the current worldwide slowdown is another thing weighing on the RBA’s mind. Plus there’s the desire to stop the decline in house prices and bring down the Australian dollar.
The chart below shows the global Purchasing Managers Index (PMI) versus the level of the MSCI world (a proxy for global stock markets):
It’s quite clear from the chart that the actual state of the world’s economy is a lot worse than the price of equities suggests. If the past is any guide, then we should be staring down the barrel of a significant correction in equities in the near future.
We all know that central bank money printing is pushing up stock markets worldwide. And quite frankly I’m getting a little tired of writing about it. But this is the world we live in. The central bankers know that all people focus on is the price of assets and whether or not they’re rising. Most people think if the stock market is going up then that means things are getting better and vice versa. Usually that would be true.
The Disconnect Between Markets and Normal Analysis
But the fact is that the markets are now completely disconnected from any normal fundamental analysis. The US Fed and ECB have lowered rates to near zero and the rest of the world is being bludgeoned into doing the same.
If the RBA left rates at, say, 5% the Aussie dollar would be flying. There are many sectors of the economy that are hurt by a strong dollar and even now they’re struggling with the Aussie near parity with the US dollar.
So we may think the RBA sets rates independently, but in reality what happens in the US has a big effect on the RBA’s decisions.
With rates worldwide being forced lower the relative prices of risk assets look more attractive, and hence we’ve seen a strong rally in high yielding stocks. As I write today the financials, consumer discretionary and property sectors are all up, as you would expect while the resources sector is down about 0.3%.
But we have to ask ourselves, if central banks have manipulated bond prices to a point where they offer very little to no value (for example real interest rates on US bonds are negative out to twenty years!) then is it correct to look at the relative values of other assets in relation to the heavily manipulated bond prices?
In other words, should you pay attention to the bond market and interest rates? Or is the mispricing of risk feeding through the system to a point where there is little value in buying almost any asset?
I believe that ultimately the latter will be correct. But as always the eternal question is when?
The chart above has me thinking that we’re closer than we think to seeing the music stop.
So when analysing the latest interest rate cut by the RBA, I’m not suggesting you pile into the banks or the retailers, because I think there are much larger macroeconomic forces at work. The unexpected rate cut shows a sense of panic on the part of the RBA, rather than foresight as they would like you to believe.
But there could be an unintended consequence to the RBA’s action. You’ve already seen a slight fall in the Aussie dollar (which I’m sure the RBA would be pleased with), but you could see a very sharp fall…which the RBA may not find so welcome.
My current technical analysis of the state of the Aussie dollar is that we’re in the early stages of a potentially large move to the downside.
The key level to watch is the 2008 high of US$0.985c. The Aussie dollar has managed to hold above this level for two years apart from a couple of retests that found strong support. The rally from the lows in 2008/9 is already looking very long in the teeth with the uptrend from 2009-2011 convincingly broken in mid-2011.
Another failure below US$98.5c may not meet the strong buying pressure that it found on previous occasions.
The Chill Wind Blowing in the Aussie Economy
With China slowing and bulk commodity prices falling, our terms of trade are beginning to trend down. So we may see capitulation by stale longs who have bought over the previous two years above that level.
A sharp fall towards the October 2011 lows of about US$0.94 (the target in the above chart) would be on the cards then, and if that level doesn’t hold you could see the Aussie dollar in the 80′s.
A sharp move such as this would certainly mean some big adjustments in different sectors. Obvious candidates for a jump would be stocks with offshore revenues. The Aussie dollar price of gold would also shoot higher and may put a rocket under our languishing gold sector.
Add in the money printing by US Federal Reserve chairman, Ben Bernanke and you could see the US dollar gold price go higher too. And that would give you the makings of a significant rally.
Apart from that I think the knee jerk reaction of buying stocks at multi-year highs due to the rate cut is misguided. The RBA knows there is a chill wind blowing, so it makes more sense to batten down the hatches than raise the mainsail.
Editor, Slipstream Trader
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Written by Murray Dawes
Murray Dawes is Money Morning’s Lead Technical Analyst. (To have his market insight sent daily to your inbox you can subscribe to Money Morning for free here).
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