Sunday, June 08, 2008

Down Under Divergence

In my recent paper on carry trade I argued that interest bearing securities in countries with low real interest rates, which historically have meant Switzerland, Japan and the United States, will provide lower value for investors than interest bearing securities than in countries with high real interest rates, such as Australia and New Zealand. An argument which might sound almost trivial for some people unfamiliar with standard international economics theory, yet which is actually anything but trivial as it contradicts the prevalent uncovered interest parity theory which argues that return should be equal regardless of where you invest as exchange rate movements should cancel out any interest rate differentials.

Recently, there has been some divergence among the currencies of the two high interest rate countries which are "down under" for those of us who live in the northern hemisphere of this planet. While the New Zealand dollar has been basically flat against the U.S. dollar this year, the Australian dollar is up nearly 9%. Meanwhile, interest rates in Australia has risen relative to interest rates in New Zealand, a movement which of course is not unrelated to the aforementioned one, meaning that nominal interest rates are now higher in Australia than New Zealand. However, if one is to believe national price indexes, real interest rates remain slightly higher in New Zealand.

The reason for this divergence is that the Aussie economy so far appears to be stronger than the New Zealand economy, meaning in turn that while rate hikes appear most likely in Australia, New Zealand is likely to cut central bank interest rates.

However, it should be noted that the slump in New Zealand appears to be a wholly cyclical phenomena caused by relatively tight monetary policies. Not only are real short term interest rates at nearly 5% one of the highest in the world, but money supply growth has turned negative. M2, the money supply gauge that in New Zealand is most appropriate, has actually contracted by 3.2% in the latest year. While consumer price inflation still runs at 3.4%, it should be noted that this is first of all lower than in most other industrialized countries, and secondly that this reflects past monetary inflation, not current monetary conditions.

As the current deflationary monetary conditions means that price inflation will likely come down relative to other countries, this means that even if nominal interest rates are cut, real interest rates in New Zealand will remain far above the rest of the world, providing support for the New Zealand dollar.

In Australia, M2 isn't published by the RBA, but of the two that are published, M1 and M3, who has recently diverged. And M1 has after the recent series of RBA rate hikes slowed quite dramatically, from 13.7% in October 2007 to 3.2% in April 2008. And if you look at the latest 6 months alone, growth was negative. M3 has slowed slightly but still remains at 20%. As the correct money supply measure lies somewhere in between them, it seems likely that the actual money supply growth, and the change in money supply growth, lies somewhere in between the numbers suggested by M1 and M3. That would suggest that although monetary inflation in Australia is still too high, it is slowing. That in turn would suggest that price inflation is likely to remain high for a while, meaning that the next move by the RBA will likely be a further increase. However, with real money supply growth ultimately shrinking, this could significantly slow the Australian economy.

As I've emphasized before, that will not mean a recession unless it is accompanied by a downturn in commodity prices, which I don't see in the near future. However, with New Zealand currently purging its previous inflationary excesses while Australia still have that before it, this would suggest that although the Aussie dollar could in the short term continue to rise versus the New Zealand dollar, the medium term outlook is actually better for the Kiwi than for the Aussie.


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