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John from Moneycorp

Australian Dollar Update 5th July 2011

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Bank again resurrects the possibility of renewed QE. Aussie prospers as confidence returns.


The Australian dollar was one of a handful of currencies to strengthen by around 2% against the pound last week. The pound began last week in reasonably buoyant mood, rising by half a cent on Monday morning. After that it was a different story. By Thursday afternoon the pound was four and a half cents off its high and at a record low. Since then it has been treading water in a cent-and-a-half range, going nowhere and shouting for help.


The UK economy was unable to throw up any convincing evidence of progress. The finalised figures for first-quarter gross domestic product served only to remind investors of the big problem that faces the chancellor and his adoring electorate: prices are going up and incomes are not. Earlier in the month the 4.5% inflation figure and the 1.8% rise in average earnings showed spending power going down by -2.7% a year. The GDP numbers confirmed that the economy grew by 0.5% in Q1 (incidentally the same performance as that put in by the United States). What they also showed, though, was that household spending had gone up in money terms while the volume of goods and services had fallen. Bluntly, Brits are paying more for less.


The rest of the week's ecostats did little to improve sterling's situation. Mortgage approvals in May numbered just under 46k, half as many as for the same month 20 years ago. Consumer confidence fell from -21 to -25 in June. Nationwide's house price index was unchanged between May and June, -1.1% lower than a year earlier. The manufacturing sector purchasing managers' index, which assesses activity and order levels, was down by three quarters of a point to 51.3 (50 represents stagnation while anything lower than that means shrinkage).


Sterling's main problem was a renewed fear that the Bank of England might decide on another round of the quantitative easing that saw it purchase £200 billion of government and corporate bonds in 2009-10. Adam Posen is the Monetary Policy Committee member who has constantly been pushing for another £50 billion to help lubricate the economy. He was at it again at the beginning of the week, arguing against the criticism by the Bank for International Settlements that the MPC was being negligent in its duty to hold down inflation. He dismissed the BIS call for higher interest rates as "nonsense".


The following day his colleague, Deputy Governor Paul Tucker, did his best to defuse the situation, saying: "This is not a committee that's drifting towards thinking that more stimulus may be needed." He told that to parliament's Treasury Committee and he might have managed to put the genie back in the bottle had he not been accompanied to Westminster by the governor and by written statements from two more MPC members.


Sir Mervyn King insisted that a further round of quantitative easing (asset purchases) is still an option because it is "... a perfectly conventional monetary policy tool. This is something we can do." As for higher interest rates, the governor also leaned towards Adam Posen's point of view. Rates would only go up "in the context of a much stronger economy, with unemployment falling rather than rising". The supporting statements from David Miles and Spencer Dale suggested both of those conditions were unlikely to arise anytime soon. One of them spoke of "risks that the recovery in output becomes weaker and then disappears"; the other said "the economic recovery in the UK remains fragile." The market's inference was that it might be another year before UK interest rates head higher.


The Australian dollar's fortunes were in the hands of Greece. As the week progressed investors became steadily more confident that Greece would swallow its austerity medicine, thus earning the next €12 billion cheque from last year's bailout fund and qualifying for a second bailout when that one runs out. True enough, the Greek parliament voted for the austerity package and then voted for the hideous details it includes — pay cuts, tax increases and all. By Friday it seemed all that remained was to compose the congratulatory telegrams.


As the Greek problem evaporated before their very eyes, investors embraced the Aussie dollar and other commodity-oriented currencies. Although there is still a massive question mark over the proposed restructuring of Greek government debt, investors feel comfortable at the moment that the authorities will come up with a way to avoid it becoming an event of default, so forcing some banks to book sizeable losses. As long as that default can be dodged, investors believe the global economy can rebuild a head of steam and, with it, an appetite for Australia's commodity exports.


The Australian ecostats did not have much to do with the dollar's spurt to stardom, partly because they were not much good and partly because there were not many of them. The best result was AiG's manufacturing PMI, which jumped by five points to 52.9. Private sector credit fell short of forecast with a 3.1% annual and a 0.3% monthly increase. New home sales were down by a monthly -0.2%, reversing the previous month's increase.


This week opened with a slump in the number of building permits issued in May. The figure was -7.9% down on April and -14.4% fewer than May 2010. Retail sales were down by a monthly -0.6%, having been expected to go up by 0.3%. Yet to come on this week's agenda are the services and construction sector PMIs, the balance of trade and the important employment numbers on Friday. On Tuesday the Reserve Bank of Australia announced its decision on monetary policy, and the expected no change at 4.75% was what transpired.


There are just three important UK data sets on the list: the services sector PMI, industrial and manufacturing production and the producer price index. There is also a vanishingly remote chance that the MPC might decide on Thursday to fall in with Mr Posen and increase the size of the asset purchase programme.


The AUD is close to record highs against the US dollar and the pound. However tempting it might be to look for a reversal, history teaches that unjustifiable currency strength is not of itself reason for a turnaround. Almost every currency move goes too far. The problem is that it is impossible to tell until afterwards what constitutes "too far". Buyers of the Australian dollar should continue to hedge their risk, and consider fixing a price for up to half the money they need with a forward purchase.

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