special reports

DailyFX Exclusive Interview with Richard Grace, Commonwealth Bank of Australia

Tuesday, 01 August 2006 14:06:27 GMT  |  Kathy Lien, Chief Strategist

- RBA Rate Hike Expected in August with Possibly More to Come

 

Key Points

Main Themes : Oil prices, Federal Reserve rate hikes, Bank of Japan rate hikes andChina

 

- Despite Chinese Demand, Australia’s Export Volume Growth is Being Held Back by Shipping Constraints, Which Should Keep Inflationary Pressures High

- 2 More Rate Hikes Expected from BoJ this Year

- Expect more Demand for Gold from India

-RBA Rate Hike Expected in August With Possibly More to Come

- AUD and NZD Relationship Breaking Down Because Drop in Agricultural Prices has Plunged Growth in New Zealand

- Movements in Australia after Surprising Data Tends to be Exacerbated in London Session

 

- 3 Month Targets:  AUD/USD – 0.77   USD/JPY – 112   EUR/USD 1.27

Kathy:

It’s my pleasure to have the opportunity to speak with Richard Grace, senior currency strategist at the Commonwealth Bank of Australia.  Let’s start by talking about the major themes in the market – what do you think FX traders should be monitoring?

 

Richard Grace:

We’ve got the oil prices shooting higher, that’s certainly a major thing - with the Middle East instability generating this latest surge in oil prices. Closer to sort of the medium term themes are what’s the Fed going to do, is it going to raise rates again, or are they going to finish their tightening cycle.

 

Third one is, how much more is the Bank of Japan going to tighten by this calendar year end. And what’s happening with China.  Are they looking to slow down as global monetary policy tightens and they monetary policy themselves – or are they going to sail right through this potential global slowdown – I wouldn’t call it a major slowdown, but a global slowdown over the next sort of twelve months – without getting affected too much.

Kathy:

                Ok, so let’s actually take each of these individually then. Starting with oil, how much more room do you think that oil prices have to rally?

 

Richard Grace:

                Depends on your time frame, of course. In the current instability that we’re seeing in the Middle East, we could see another five dollars, seven, possibly even ten dollar spike in oil depending on whether the US gets involved, whether it spreads out to other countries, and Syria and Iran become more involved, so it’s difficult to determine that. In terms of a longer term outlook for oil, we could see it going another five to ten dollars a barrel lower. But we think that we get a slight slowdown in the global economy, and that will take a little bit of heat out of the oil prices, which may bring it back another ten dollars because there’s probably at least five to seven dollars of oil premium built in, some people talk about ten to fifteen dollars worth of war-risk built in, but that probably gives you an idea of your range, another seven to ten on the upside.

 

Kathy:

                Oil prices increase inflation, so at what point is it inflation versus growth that will cause the Fed to decide whether they’ll raise interest rates to five and a half or six percent?

 

Richard Grace:

                I think the immediate focus will be on inflation, because growth is holding up very well. While the US economy is cooling a little bit, I think the US authorities are surprised at just how much private consumption is holding up, given the slide we’re seeing in the housing sector, some of those housing indicators are already back to 2003 levels, if we take the NAHB index, the National Association of Home Builders index, that’s already back to 1995 levels, without too much of a slowdown on private consumption in the US, which is still traveling around the 3% level year on year. And let’s not forget private consumption makes up 70% of the US economy.

 

Kathy:

                Ok, even if we’re at $80 oil, do you think that the Federal Reserve could continue to raise rates?

 

Richard Grace:

                I think they’re going to tread very carefully, because high oil prices are certainly a tax on growth, and while the Fed may want to raise interest rates to offset any inflationary pressures, they’re very conscious of the fact that oil prices are by themselves slowing down the economy, so if they raise rates too much, it could tip the slowdown too aggressively. So, I think, they’re going to tread very carefully, but have a keen focus on inflation in the short term, because I think they’re quite confident over the longer term economy’s resilience.

 

Kathy:

                So if you want to figure out when the Fed may end their tightening cycle, aside from inflation indicators, what would you look at?

 

Richard Grace:

                You can’t go past the employment indicators and the ISM index for those sort of purposes. Also, I would keep a hot-pinned eye on the housing indicators because they’re very important, as we talked about. I would also keep an eye on the commodities markets because if there’s going to be a slowing in demand, we’re going to see some of the commodity prices start to come off, and not just sort of a knee-jerk reaction to a little bit of global instability or perhaps weakness in some of the equities markets, but if the equities, metals markets start to trend down, I think that’s a very good indication that things are slowing down globally.

 

Kathy:

                Ok. Now at this point, all the central banks are raising interest rates in order to combat inflation, so, do you think that tighter conditions will have a ripple effect in the economy and at what point do you think is the tipping point?

 

Richard Grace:

                Oh, I think the global economy is going to show  a lot more resilience than most people are giving it credit for, for two reasons.

               

                One is because global monetary policy was very easy, for a long period of time. In fact, if you take an average of global monetary policy conditions, we have got some charts that show conditions a couple of years ago, between 2001 through 2003 were probably the easiest they’ve been for a couple of hundred years, so in other words you’ve got a situation where easy monetary policy has been in place for a long period of time.  The momentum that we’re seeing now as the world has more or less capitalized on those global monetary easy conditions is going to take a long time to unwind, so momentum in the global economy is quite strong.

 

                The second reason why we’ve got resilience is how well China is going. And China is now demanding more exports from the rest of Asia than the US is, which has been a fundamental shift in the global economy from just five years ago.

 

Kathy:

                How much of Australia’s exports go to China?

 

Richard Grace:

                Ten percent of Australia’s exports go to China. Their biggest export partner is Japan, by quite a long margin, and China takes about ten percent of our (Australia’s) exports. It’s grown significantly over the last few years.

 

Kathy:

                What do you expect that growth in China will be in the next five years? Do you expect it to be up to twenty percent?

 

Richard Grace:

                I doubt that China will grow that fast. The main thing that is going to hold back Australia’s exports to China is shipping the physical volumes away, because most of the exports that China takes from Australia are bulk commodities, and there’s capacity constraints on the Australian ports, physically getting the bulk commodities on board the ships – there’s also a shortage of ships – and shipping it away to China. So, export volume growth has been somewhat restricted out of Australia towards China, so if the growth rates aren’t stronger that’s the major reason why.

 

Kathy:

                Have you been seeing Chinese corporations buy Australian corporations? This is  a trend we seen in Canada, is it the same in Australia?

 

Richard Grace:

                There’s been a lot of interest, yes. And I think we’re expecting to see growing interest. The most recent interest which springs to mind is interest from the Chinese in buying some uranium companies in Australia.

 

Kathy:

                How long do you think Chinese demand will continue its current growth before actually slowing and having it affect Australia?

 

Richard Grace:

                Well, I can see Chinese economic growth averaging eight to ten percent for another ten years at least.  Industrialized economies, South Korea, Taiwan, Singapore, also did the same pace of growth. China’s gone through about twenty five years of eight to ten percent average for another ten years.

 

Kathy:

                In terms of the Bank of Japan, there is the belief that many speculators have been short the Japanese Yen to fund both commodity and carry trades so if the Bank of Japan begins to aggressively raise interest rates, there could be a sharp liquidation in commodities - is that something that we should worry about?

 

Richard Grace:

                I think that the Bank of Japan’s usage of the word gradual is very similar to the Fed’s usage of the word measured.  The Bank of Japan has seen the Fed tighten monetary to great success and probably wants to do the same. They have been increasing rates from one percent up to five and a quarter percent in a measured fashion without creating instability in the local economy, that is, the US economy, and globally for that matter. I think that the Bank of Japan would very much like to do the same as they move interest rates zero up to wherever they’re going to finish at the end of the cycle.

 

Kathy:

                Well, do you think it’s more difficult for Japan because even though US rates were one percent, it seemed that people used the yen more for carry trades than the dollar. So they have a much more at risk – that is if they do it too much, the moves could be much more exacerbated.

 

Richard Grace:

                On the yen, but the Bank of Japan is going to be perhaps more focused on, the domestic economy and monetary policy in there and how the domestic economy responds to the increase in interest rates. They’re going to be less concerned about how the yen moves, within reason. If you get sharp volatile movements in the yen, within either direction for that matter, the Bank of Japan is going to be a little more alarmed. 

 

Kathy:

How many more interest rate hikes do you expect from the Bank of Japan?

 

Richard Grace:

                Two more this calendar year, with probably more in the next calendar year as well.

 

Kathy:

                And how does this impact the commodities market because a lot of people have said that says people use that money to fund commodity purchases.

 

Richard Grace:

                Commodities markets are very much influenced by the hedge funds at the moment, because the global size of the commodities markets is only about two to three hundred billion US, it’s relatively small compared to a one and a half trillion dollar a day foreign exchange market, or an equally large global equity market and bond market.

 

                So, hedge funds are able to push commodity prices around. I don’t think they’re necessarily using the yen carry trade in order to push the commodity markets around, so if conditions tighten in Japan, monetary policy conditions that is, I don’t think it’s going to affect the speculation of the commodities market as much as some people might think. I think it’s the China story which is affecting the speculation in the commodities markets rather than the BoJ tightening story.

 

Kathy:

                What about gold prices? Now, gold prices have also had a very significant run and gold impacts Australia a lot more. Do you see that having much more room to rise, because oil is something we need to use, gold is more inflation hedge?

 

Richard Grace:

                I do think gold has got further to run simply because we are seeing a little bit of concern over inflation. Gold has traditionally been a hedge over inflation, so there will be some long term participants in the market who will continue to trade gold for those reasons. We are seeing actual central banks getting a little more interested in gold, reversing the trend of a few years ago. Also it is a commodity that is becoming more widely traded, and the final reason if you like is that as India’s economic growth cycle, or as India’s economy expands, it becomes a little wealthier in each step of the way. India is the largest consumer of gold in the world, and we’re going to see perhaps increased demand from the Indian side as they continue along their economic income cycle.

 

Kathy:

                So do you that that as gold prices continue to rise that this could cause conditions in Australia to improve and then cause the Reserve Bank of Australia to consider raising rates?

 

Richard Grace:

                No, I wouldn’t go so far as making the link to be that strong.  I think a rise in the gold price will have an insignificant effect on the Reserve Bank of Australia’s decision. A rise in the gold price will certainly help some of the mining companies in Australia, which are already enjoying boom times, so it will certainly add to Australia’s wealth on the income effects from that perspective, but not enough to cause the RBA to raise interest rates.

 

Kathy:

                Now what about the impact on the Australian dollar itself? Will that have enough?

 

Richard Grace:

                To a certain extent, but I think by and large the link between commodity prices and the Australian dollar has largely been severed. I won’t say they’re completely severed, but if you look at where commodity prices have gone over the last few years and where the Australian dollar has trended over the last few years, they’ve gone in virtually opposite directions.

 

                And so the strong link between commodity prices and the Australian dollar, which has been a strong link for the best part of more than twenty years, is becoming less clear because the Australian dollar has not gone as far as you would expect given where commodity prices are.

 

Kathy:

                Why do you think that is the case?

 

Richard Grace:

                Two reasons. One is it comes back to what I mentioned about the size of, the way hedge funds are pushing commodity prices around, it comes back to the size of commodity markets, they’re relatively small, two to three hundred billion US, and so while the can be pushed around by hedge funds, the participants in the foreign exchange market, perhaps they’re not influenced by the amount of speculation going on in the commodities market, when other factors are driving the exchange rate market and so are not getting carried away with the speculation that’s going on in the commodities market.

 

                The second reason is because there is mostly a massive inflation response in Australia as a result of the commodity price boom and so therefore the Australian dollar doesn’t have to rise to offset that inflation response.

 

Kathy:

                Now, going back to the Australian economy in general, what are the major things affecting it, how it is doing at the moment?

 

Richard Grace:

                It’s very much affected by the global economy, so the strong global growth we’re seeing at the moment is having a massive windfall for terms of trade income injection into the economy, it’s in the order of about two percentage points. In other words, the GDP figures tell us that the Australian economy is growing three percent year on year, or 3.1% to be exact but if we account for the terms of trade, it’s growing 5.1% year on year. So it’s a massive income injection into Australia.

 

                The other factor which is affecting the Australian economy is the influence of the housing cycle.

 

Kathy:

                And how has the housing market been impacting the economy?

 

Richard Grace:

                Well, Australia’s economy has been through a massive house price boom, and now we’re seeing a slow, gentle deflation of that bubble, if you’d like to call it that, and it does affect Australia’s economy because it is a very, relatively small but volatile sector, has large multiplier effects into the local economy, and we’ve also got a pattern of a lot of diversion in the, in the housing market in Australia.

 

                In other words, we’ve got the booming housing market in Western Australia, where that part of the country undertakes a lot of commodity exports, whereas, in the, sort of, in the manufacturing side of the economy and the service side of the economy, which is located in Melbourne and Sydney, we’re seeing housing prices really slow down there, and in some cases, we’re seeing house price falls. Household consumption in Melbourne and Sydney is starting to slow right down, being offset by the household consumption in Western Australia. So to answer your question, it’s having diverse effects and it did have sort of a dampening effect as the house price boom starts to deflate. But now things are starting to nationally pick up on average.

 

Kathy:

                So then, where does that put the RBA for the rest of the year?

 

Richard Grace:

                Well we think that the RBA’s going to hike again in August.. Major reasons for that is because we are seeing that massive income injection from the terms of trade into the Australian economy is providing a little bit of inflationary pressures. We will see the release of the quarterly inflation numbers coming out on the 26^th of July. We think that that’s going to lift the year on year inflation rate from 3% up to possibly as far as 3.6%, well above the Reserve Bank of Australia’s two to three percent target zone for inflation and hence the RBA will inflate rates in early August.

 

There is still the problem of capacity constraints that I mentioned earlier, that is that the port facilities are putting a little bit of pressure on prices in Australia. We’ve got the unemployment rate at a thirty year low, 4.9%, that’s been confirmed for the second consecutive month, and add to that a little bit of labor shortages. So with the combination of a strong global economy and increasing domestic demand, I think the RBA will hike rates in August, and there is a risk of a further rate hike further down the line. 

 

Kathy:

                Typically, the Australian dollar and New Zealand dollar is very well correlated but it seems like the relationship has broke down recently. Why do you think that’s the case?

 

Richard Grace:

                Because we got the New Zealand economy almost tinkering with a recession, while the Australian economy is picking up. So the two economies are going in different directions. The interest rate market is pricing in interest rate hikes for Australia and interest rate cuts for New Zealand, so we’ve got a lot potential to see the Australian dollar and New Zealand dollar move in opposite directions.

 

                One final point to that, I think we’ve seen in the increase in sophistication of hedge funds in the market hedge funds have grown exponentially. A lot of markets used to consist of just trading two currencies as a region, as by commodity currencies, as by or by current account deficit. Increased sophistication is now seeing them traded very differently with different economic fundamentals

 

Kathy:

                How is the Zealand economy doing? What are the risks?

 

Richard Grace:

                House price boom and now a gentle deflation is one, two is interest rates have gone to quite high levels, seven and a quarter percent on the base rat. Three is that they mainly export agricultural products and agricultural prices have fallen ten percent in SDR terms, that is, special drawing right terms, which stripped out the currency effects. So while commodity prices are rising virtually everywhere else  they’re actually falling in New Zealand, so they’re not enjoying the stronger global economic conditions as, say, some other smaller economies are.

 

Kathy:

                So then why is there such a divergence? Why is Aussie tracking Kiwi, or sort of falling in sympathy to Kiwi, versus the usual reverse correlation.

 

Richard Grace:

                I think we are seeing a little bit of divergence. At times when you get a large unexpected weakness to either economy the other exchange rate can perhaps go in the same direction in sympathy for a short period of time, but over sort of a couple of days, at the very least, if not within 24 hours, the exchange rates tend to diverge back to the paths which are fundamentally driving them. So I think we’re seeing increased divergence in those currencies.

Kathy:

                Do you think that will continue for some time?

 

Richard Grace:

                I do.

 

Kathy:

                Ok, and any three-month targets for the euro-dollar, dollar-yen, aussie-dollar?

 

Richard Grace:

                For Aussie dollar we’re looking at 77 cents in the next three months. In dollar-yen, we’re seeing a fall back to 112, and euro-dollar, we think it could get back to 1.27

 

Kathy:

Now lets talk a little bit about what you think our traders should look at. So what do you think are the top five indicators that are most important for Aussie traders to follow?

 

Richard Grace:

                The Australian euro two year bond spread number is without doubt number one.

 

Kathy:

                What do you think that correlation is? Is it a fairly strong correlation?

 

Richard Grace:

                Yes, yes, certainly, it’s in the high eighties possibly.

 

Kathy:

                Is it a leading or lagging indicator? By how much?

 

Richard Grace:

                The maximum lag is six months, maximum, but I think you can almost trade it on a day to day basis.

 

Kathy:

                Ok.  What else?

 

 

Richard Grace:

I think the London metals exchange base metal summaries is also a good one. Probably the one we would emphasize is CBA’s index of commodities

 

Kathy:

                Is that readily - can you find that on…

 

Richard Grace:

                Can you find that on Bloomberg? Yeah. I’m not sure about Reuters, but you can certainly find it on Bloomberg.

 

I’d also look at the Asian currencies, see how they’re performing because the Australian dollar has a strong link to the Asian currencies, mainly as a result of Australia’s large trade link with the Asian region, Australia does sixty percent of its trade with the Asian region.

 

                The US dollar, what that is doing, because the Australian dollar does trade with the US dollar. 

 

They would be the four strongest indicators I would look at.

 

Kathy:

                What about your top economic data to follow?

 

Richard Grace:

                Employment numbers. Australian employment numbers are an excellent determination for the Australian dollar. One point I’ll add to that too, is if for example  there is a big move after a number in Australian time, by the time London opening comes up six, seven hours later, you’ll generally see the Australian dollar accelerate its movements that it’s done just after the employment numbers are released in Australia at 11:30 local time. So you do tend to see an exaggeration in the London opening of what you saw in the Australian opening. In the US you can get something completely different, or it can go in the same direction.

 

Kathy:

                Do you think that’s a trend in general?

 

Richard Grace:

                Yes

 

Kathy:

                With any kind of major releases?

 

Richard Grace:

                I do, actually, though the employment numbers stick out more than most, the others would be the trade numbers and the inflation figures because the inflation figures come out quarterly in Australia, they don’t come out monthly like they do in the US.

 

Kathy:

                What about the New Zealand economic data? What are the most important?

 

Richard Grace:

                The US New Zealand 1 year – 1 year forward spread is very useful for predicting the direction of the NZD. 

 

The economic data to focus on are inflation numbers, they’re going to have the biggest effect on the New Zealand dollar and while they sound like a long way apart because they’re quarterly releases, most of the data released in New Zealand is quarterly, even the employment numbers are released quarterly and that’d be the third one I’ll throw into the mix.

 

Kathy:

                What about migration?

 

Richard Grace:

                That is also an important driver - the link between migration is flowed out into housing and how the housing effect increases, and migration can significantly drive growth in the economy through that channel. You can look at that on a monthly number, the trade numbers also come out monthly, they would be the two other ones you can look at but they’re not as important as the earlier three I mentioned, inflation, employment and GDP.

 

Kathy:

                Do you think the Australian dollar currency pair has wider range during Australian trading hours or sort of London/US hours?

 

Richard Grace:

                Wider during the offshore hours.

 

Kathy:

                Is that just because of liquidity, less traders in Australia?

 

Richard Grace:

                Yes

 

Kathy:

                And finally, how can a new trader do more research or keep up on how well the Australian/New Zealand economies are doing aside from DailyFX’s weekly report?

 

Richard Grace:

                Commonwealth Bank of Australia’s got a good website on economic research and foreign exchange. You can have a look at some of the local newspapers as well if you like.

 

Kathy:  Thank you so much for taking the time to speak to us!

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