Why a Strong Dollar Could Mean Higher Interest Rates

aussie dollar interest rates

Here we are at the start of another month, which means another interest rate decision for the Reserve Bank. Not that there will be much to decide on. It’s more than likely the RBA will, once again, keep rates on hold.

With the Aussie dollar pushing towards 80 US cents, Governor Phillip Lowe won’t want to give currency markets any reason to push our dollar higher.

However, there may be a shift in thinking on this in the next few months. It really all depends on how the residential construction sector handles the slowdown of the building boom of the past few years.

So far, it seems to be going nicely. That is, despite concerns about a construction bust, the slowdown seems orderly so far. And then there’s the supposed government infrastructure boom, which could absorb any drop off in residential construction.

What does this have to do with the strength of the dollar?

The dollar usually rises when the Aussie economy is strong. Well, maybe not exactly strong, but healthy at least. It rises when more capital flows in than flows out.

So at the very least, a strong dollar reflects a vote of confidence by international creditors. This is important for Australia. We have a net debt position of over $1 trillion dollars.

What does this mean?

Put simply, it means that foreign investors have loaned us over $1 trillion dollars to fund our standard of living (including our houses). If they feel their investment is at risk, they will pull their funds out, and the dollar will plummet.

That’s obviously not happening right now. Our international creditors feel that their money is safe in Australia.

Which is worth keeping in mind when thinking about property and the risk of the bubble bursting. A big portion of our foreign debt sits on the big banks’ balance sheets, loaned to us for the purpose of buying property.

So while there is a ‘property bubble about to burst’ article every other day in Australia, our foreign creditors don’t seem so concerned.

That’s because Australia’s primary income earner, commodities, are rising in price again. This means our national income is growing, which in turns spreads throughout the economy, creating jobs and borrowing power. (We all borrow against our income, right!?)

The question for the RBA — which will decide the trajectory of interest rates — is just how far will commodities run?

The following chart is crucial. Its shows Australia’s terms of trade. When the terms of trade rises, it effectively represents a pay raise for Australia, or an increase in national income growth. A falling terms of trade means the opposite.

It’s hard to see on the chart below, but the rising terms of trade corresponded with a rising Aussie dollar, and — during the latter stages of the terms of trade boom — rising interest rates.

Australian Terms of Trade Index 1950-2017
[Click to open new window]

The point I’m making here is that a strong Aussie dollar will only keep the RBA on the sidelines for so long.

A strong dollar reflects confidence in the economy. It reflects strong capital inflows. If household consumption and other areas of the domestic economy pick up pace in the months ahead, and the terms of trade remains strong, expect the RBA to start talking about rate rises despite the strength of the dollar.

The main thing holding the RBA back from moving right now is weak household spending. That’s largely because of the huge debt burden households are carrying. Combined with low wages growth, that debt burden means households aren’t spending as fast as they used to.

A rising terms of trade may change that in the future. Rising national incomes may translate into higher wages growth. But it will take a while for that to become apparent. And I think the RBA will be happy to sit around and do nothing until it sees evidence of wages growth.

With households weighed down by debt, that’s translating into weak corporate profit growth. The reporting season, which just wound up, wasn’t too inspiring. The standout was the resource sector, with profits rebounding strongly from a low base.

But the rest of the corporate sector (in the aggregate, anyway) paints a picture of an economy growing tepidly.

For all these reasons the RBA will more than likely keeps interest rates on hold today. But as I said, they may start to change their tune shortly.

One other thing causing concern for households is rising energy costs. Despite having abundant reserves of cheap energy, Australia has royally stuffed up its energy policy. And that’s resulting in rising energy costs. As The Australian reports:

Australians are at risk from a dangerous shortfall in baseload power that could drive up household electricity bills, according to a new report to the Turnbull government that comes as more voters turn away from paying higher prices for renewable energy. 

The government has been warned of a looming gap in the national electricity supply as coal-fired power stations shut down, highlighting the need for urgent decisions to build new generators that operate around the clock.

The findings, delivered to Malcolm Turnbull and key ministers yesterday, come as consumers ring the alarm on the hit to their budgets from the upheaval in the energy market, with 49 per cent declaring they will not pay a cent more for renewable power.

As you no doubt already know, household electricity and gas bills are already rising. Along with low wages growth, this is an additional tax that restricts spending.

One way to hedge against these costs is to have a punt on some Aussie energy juniors. It’s a way of playing what I believe will be rising oil and gas prices, and the ‘energy shortage’ in Australia.

My most recent picks are already off to a flying start. One is up nearly 60% from the initial recommendation, while another is up 25%. That’s just in the past two weeks. Over time, I think there is plenty more to come.

To find out more, click here.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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