Australian dollar headed for a fall as Reserve Bank mulls interest rates cut

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To cut, or not to cut? That is the question.

After years of coasting along on the back of outrageous fortune, Reserve Bank princeling Philip Lowe, as another famous plutocrat once observed, may just be forced tomorrow to take up arms against a sea of economic troubles.

Right now, there’s an even money bet as to whether the Reserve Bank will shave another quarter of a percentage point off the official cash rate. Ultimately, the debate is not about if, but when.

If it doesn’t move tomorrow, it most likely will be next month. And there will be at least two within the next few months.

Two unrelated factors will be weighing on the governor’s mind at tomorrow’s meeting.

One is the upcoming election and the potential political fallout from a rate cut in the final days of the campaign. 

The other potentially more significant factor is that the US Federal Reserve chief Jerome Powell may just have delivered Mr Lowe some breathing space.

Rates and the AUD in 2019

Rates and the AUD in 2019

What will interest rates and the Aussie dollar do in 2019? Business reporter Michael Janda asked half a dozen experts to get their views on the outlook.

By thumbing his nose last week at US President Donald Trump’s demands to cut American interest rates, the American central bank boss has put our currency under pressure.

On Friday, the Aussie battler spent most of the day below US70c, a situation that would have delighted the boffins down at the Reserve Bank. For their entire focus now will be on undercutting the currency in an effort to boost growth and inflation. And the best way to do that is through slashing rates.

The case for a cut

The long, grinding downturn in our housing market finally has begun to bite. Last week, both the ANZ Banking Group and NAB highlighted a small but significant uptick in the number of homeowners having trouble repaying mortgages.

According to ANZ’s numbers, almost 5 per cent of households now have slipped into what’s known as negative equity. That’s when you owe more on the house than it’s worth.

It’s a situation that can become serious if unemployment rises. Not only do defaulting borrowers lose their home, they still end up with debt. And losses start mounting in the banking sector, ultimately putting the economy further under strain.

The scourge of negative equity

The scourge of negative equity

Mortgage delinquencies are on the rise, house prices are still tumbling and borrowers are falling into the quicksand of negative equity in their property. It’s bad.

That’s also starting to impact spending. On Friday, the Federal Chamber of Automotive Industries reported an 8.1 per cent drop in new car sales in April compared with a year earlier while MotorCycle Holdings told the stock exchange the motorcycle market had shrunk 14.6 per cent in the first three months this year.

Add in an inflation reading of zero in the March quarter and a plunge in annual GDP to just 2.3 per cent, and there are some pretty compelling reasons to cut interest rates right now.

Waiting for unemployment to deteriorate, as some suggest the RBA should, would be leaving things too late.

Would a rate cut stop the housing rout?

It may slow the decline but it won’t halt it.

Demand is being crimped by the sudden introduction of responsible lending. On the other side of the equation, supply is about to explode with several hundred thousand new apartments about to hit the market. 

Those two factors combined can only mean one thing; further falls in housing prices.

So, why bother with a rate cut?

NAB’s interim boss Phil Chronican last week forcefully argued there was little to gain from another cut to interest rates. 

“Monetary policy has a lot of potency when it’s at high levels … when they are at low levels, it just doesn’t have the same effect,” he said. 

Rate cut crescendo mounting

Rate cut crescendo mounting

The calls for rate cuts are getting louder, but will they work and are they even necessary?

He’s right in some respects, so long as you are looking purely at internal dynamics. But his comments largely missed the point.

The real objective behind a rate cut is to sink the Aussie dollar.

In decades past, before deregulation, a weak currency was considered political suicide. Oppositions would seize upon a devaluation as a sign of economic mismanagement.

Not any longer. Governments and central banks for decades have been engaged in a race to the bottom when it comes to currency. 

A weak currency boosts an economy by making exports cheaper, and therefore more competitive, and imports more expensive, which puts domestic industry on a stronger footing. 

Why it will work this time

Australian competitiveness was belted out of the park by the mining boom. When our currency soared to almost $US1.10, a large swathe of our industry, particularly manufacturing, was hollowed out. It was the final nail in the car industry’s coffin.

The Great Recession made things even worse. The developed world, led by the United States, fought a currency war that took no prisoners. We were among the casualties.

Between them, the US, Japan and Europe printed vast sums of cash; the idea being that increasing the amount of cash lowered their currency’s value. The US alone pumped an extra $US3.5 trillion into the economy.

Chart showing Australia and USA's interest rates.

Australia was too small to take part in that war. But we can now; not through printing money, but simply by cutting rates. For most of our history, Australian interest rates have been higher than the United States and other developed nations because we needed imported cash to fund our development.

But that’s all changed. As the graph above shows, last year, US official rates climbed well above ours and it looks as though this will be no fleeting phenomenon. America’s economy is rebounding and we’re slowing. On Friday night, the US jobs numbers were way better than expected.

Property outlook for 2019

Property outlook for 2019

Policymakers have embarked on the delicate task of deflating a property bubble without bursting it — this year we’ll find out if they’ve succeeded.

It’s not so much the level of our rates that matters. On that point, Mr Chronican is correct. But the gap between our interest rates and America’s will have a big impact on the currency. It’s what’s known as the spread. 

The wider it gets — in America’s favour — the weaker our dollar will become. That’s because investment funds looking for a decent return, will scarper offshore in search of higher yields. 

As our dollar sinks, inflation, in theory at least, should escalate. And wages should follow, helping Australian households overcome the mountain of mortgage debt now weighing them down.

A weaker dollar will deliver bigger returns from our mineral and agricultural exports. Plus, it will ramp up our service industries; education and tourism among them.

The US central bank had planned to continue boosting interest rates through 2019. But last year’s stock market plunge in the lead up to Christmas, which sent Mr Trump apoplectic, kyboshed that idea.

If the US had continued hiking rates, we may have been able to merely sit on our hands for a few more years, as America widened the interest rate gap for us. 

That’s no longer an option. The US now is likely to sit still. The onus now is on Philip Lowe to don the armour.

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