After a stellar move to cut rates by the RBA in February, we were hugely disappointed with the statement at the March meeting and then again in April.
The domestic economy is getting progressively worse; the iron ore price fell from over $60 to $51 in the space of just one month and many miners are now close to the break-even level on the cost of production.
Acknowledging this truth can be difficult for some, but a falling currency is the easiest way to gain back competitiveness that has been lost.
If the RBA really wants the Australian dollar to fall, their best bet is to win the currency wars by cutting rates even more proactively than the competition. Unfortunately, if the banks’ concern over the housing market delays it cutting rates for too much longer, the domestic economy will weaken further.
Ever since the GFC, which saw rapid deterioration of the US housing market, there has been a view that monetary policy shouldn’t just be targeting consumer price inflation, but house price inflation as well.
We’ve said before that this is dangerous, and for good reason. Firstly the central banks of most economies have input, if not direct control, over the agencies that regulate the banking industry. They control capital requirements, and can even outright stop lending to certain types of individuals if they wanted.
When we look at a central bank that targets house prices through monetary policy, they implying they don’t have trust in the banks to allocate capital or the regulators to enforce it.
What really happened in the US was a failure of regulation, and while the reasons for this are many, monetary policy wasn’t one of them. If rates were lifted another 2%, what would a borrower of an adjustable rate mortgage with no payments for the first three years care? The existence of these mortgage products in the first place was the true problem.
The focus in Australia on house prices (in Sydney) is misplaced because all of the key fundamentals that drive the ability to service mortgages are getting worse. Unemployment is increasing, real wage growth is weak and there is evidence of rents weakening in select areas, indicating falling demand.
The RBA has dangerously been relying on US Federal Reserve hiking cycle to start to get the Australian dollar lower. This reliance will be challenged if the Federal Reserve doesn’t hike and even if they are right, this would only help the Australian dollar directly against the US dollar. We find it hard to understand why this is important when the US doesn’t constitute a super-dominant trading partner any more.
The RBA seem to be worried about getting below the 2% interest rate bound for an undisclosed reason, possibly fearing that the cuts won’t have any effect. The ‘lucky country’ is still an incredible place, but regrettably our run of good luck looks to have come to an end for now, and the worst the RBA can do is ignore that.
What’s an investor to do? Looking forward we continue to run a defensive and liquid portfolio with a deliberate long-volatility tilt. We believe that risk assets are increasingly vulnerable to a ‘shock’ event and that longs in Australian bonds and the US dollar are the best positions to own in this environment.