The extraordinary, globally coordinated fiscal and monetary response to the Great Recession is to continue unabated, according to the latest statement from G20 Finance Ministers and Central Bank Governors, even as economic conditions continue to improve. Under these conditions, stock markets the world over are likely to keep appreciating although the ride will be bumpy.
â€œUnprecedented, decisive and concerted policy action has helped to arrest the decline and boost global demand,â€ the statement said. Â â€œFinancial markets are stabilizing and the global economy is improving.â€
No doubt exists about that; the S&P has made back just over 38.2% of the decline from the Oct. 2007 peak to the March 2009 low. But policymakers went on to assure investors they will â€œcontinue to implement decisively our necessary financial support measures and expansionary monetary and fiscal policies, consistent with price stability and long-term fiscal sustainability, until recovery is secured.â€
The question now is what this implies for currency valuations. The dollar generally weakens against the better-yielding currencies as stocks improve but a closer look at how this is working is important now. For example, the S&P hit a resistance level during the first 10 days of June before weakening and finding support near the 875 area (the 23.6 Fibonacci level of the entire peak to trough move). Since then, itâ€™s grown 6.26% from the June 11 peak and by 16.88% from where the last level of support was found on July 10.
Meanwhile, the euro has gained 1.40% against the dollar since June 11 and 2.79% since July 10 while the pound has been virtually flat over the period. Â The big winner in percentage terms has been the Australian dollar, with gains of 6.20% and 9.53% respectively.
The reasons for this are fairly straightforward; the Australian economy has fared better overall than either those of Europe or the U.K. Even more importantly, the interest rate differentials are far in Australiaâ€™s favor especially when you look at the spreads over Treasuries on the shorter end of the yield curve.
Two year Treasury bonds were yielding just 0.93% at the close on Friday while similarly dated Australian government bonds yielded 4.5% or 357 basis points more. Meanwhile, the spread between German bunds and Treasuries was just 15 basis points while U.K. gilts yielded 6 basis points less than the U.S. 2 year.
So there are 2 questions now-will global asset values continue to improve and is Australia likely to maintain its yield advantage in government bonds, therefore continuing to make the A$ the best bet against the USD. The answer I believe is yes and hereâ€™s why:
First, as we know from the G20 statement, aggressive and expansionary fiscal and monetary policies will be continuing for quite some time. How long? At least until inflation (U.S. CPI) turns well into positive on a year over year basis because as inflation goes negative (-2.5% in the year to July), the real cost of borrowing increases.
Second, because the Australian economy figures to continue doing better than any of its Western counterparts (vis a vis commodity demand from China and the other parts of Asia), the RBA is likely to be the first Central Bank that will begin to make sounds regarding increased borrowing costs.
Whatâ€™s the risk to this scenario? That investors will become truly nervous about U.S. deficits and drive interest rates higher. But the possibility of this happening in the short term is basically zero unless China stops purchasing Treasuries, which cannot happen anyway because the yuan would appreciate rapidly if they did (the latest TIC data for June showed that China bought over $26 billion worth despite all the concerns they voiced over dollar valuations).