OK – the US economic recovery still seems robust enough to see the US Federal Reserve moving to hike interest rates over the next couple of years. It is not fanciful to suggest that the Fed funds rate will be near 1.5 to 2 per cent some time in 2016. Hardly draconian, but it would be part of the long run process of normalising monetary policy after the Lesser Depression of 2008 to 2011.
In Australia, the free-fall in the terms of trade, fiscal tightening, persistently glum consumer sentiment and the near certainty that house prices will stop rising – they could even fall modestly – suggests that the RBA will be moving to cut interest rates in the not too distant future. Indeed, it is not fanciful to think that the cash rate in Australia will be near 1.5 to 2 per cent some time in 2016.
The divergent economic trends and monetary policy settings will also play into the bond market. US bond yields will rise as the Fed hikes interest rates and the 10 year bond, currently yielding around 2.5 per cent, would likely trade near 3.5 per cent on the back of solid and sustained growth and Fed interest rate hikes.
For Australia, in a disinflationary funk, it would be likely that 10 year yields would fall from current levels around 3.5 per cent.
See what is happening?
The whole Australian yield curve starts to trade through that of the US. Interest rates in Australia will be lower than the US.
That call would lead to a very sharp AUD depreciation. With Australia losing its interest rate advantage, investors would look to other reasons to buy Australian dollars – but alas for the Aussie dollar, none of those would be favourable and indeed, most would also signal a “sell”.
Falling terms of trade, a wider international trade deficit and emerging problems with government finances are all bad news for the Aussie dollar. The only question now is how far will it fall?
Back in February 2014, Deutsche Bank issued a report suggesting the Aussie dollar could fall to 66 cents over coming years. A wild call for sure, but one that now looks as though it just might be a little more realistic as the interest rate gap closes, the terms of trade free fall and confidence in the Australian economy is smashed by policy intransigence.