Reserve Bank of Australia Revives the Ghost of Inflation Past

After the Reserve Bank of Australia (RBA) decided to leave its interest rates unchanged last month, the Australian dollar sold off for a week against the U.S. dollar. The decline reversed the small rally leading into the decision on monetary policy. AUD/USD enjoyed a small rebound going into the May decision on monetary policy and then jumped after the RBA threw markets for a loop by hiking interest rates again. More importantly, the RBA quickly revived the ghost of inflation past. The RBA undermined any assumptions that it would be content to watch inflation try to guide itself from 7% down to the 2% to 3% target range. The previous pause in rate hikes did not seal the deal on the fight against inflation.

The 15-minute chart of AUD/USD shows how traders rushed to buy in the wake of a surprise rate hike. The enthusiasm peaked within 3 hours. (Source: TradingView)

The RBA acknowledged that “inflation in Australia has passed its peak.” However, inflation at 7% is too high and “…while the recent data showed a welcome decline in inflation, the central forecast remains that it takes a couple of years before inflation returns to the top of the target range.” This inflation horizon means the RBA could intermittently hike rates for quite some time as it scours the landscape for smoldering embers of inflation.

The current problem is in services price inflation. The U.S. also faces this challenge. Indeed, he RBA referenced global commonality in explaining the sources of stubborn highly inflation (emphasis mine):

“Goods price inflation is clearly slowing due to a better balance of supply and demand following the resolution of the pandemic disruptions. But services price inflation is still very high and broadly based and the experience overseas points to upside risks. Unit labour costs are also rising briskly, with productivity growth remaining subdued…Wages growth has picked up in response to the tight labour market and high inflation.”

The RBA further explained that the rate hike should firmly anchor medium-term inflation expectations. Tightening monetary policy is acting like an insurance policy against higher inflation expectations contributing “to larger increases in both prices and wages, especially given the limited spare capacity in the economy and the historically low rate of unemployment.” Unemployment in Australia remains at a 50-year low. Thus, the RBA has plenty of room to continue tightening as needed…at least for now. The RBA acknowledged the challenge ahead in avoiding a recession while it tightens monetary policy:  “the path to achieving a soft landing remains a narrow one.”

The RBA concluded the May statement on monetary policy just as it ended the previous statement: “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve.” In other words, the market will need to stay on its toes.

The Trade

The intraday surge in AUD/USD was not enough to punch the currency pair through important resistance on the daily level. AUD/USD remains trapped underneath resistance from all three major trendlines: the 20-day moving average (DMA) (dashed line), 50DMA (red line), and the 200DMA (blue line). Thus, I am neutral on AUD/USD until at least after I see how the market responds to the Federal Reserve’s turn to announce monetary policy.

AUD/USD has been stuck in a range for two months. Resistance from the 20DMA, 50DMA, and 200DMA are now capping upside. (Source: TradingView)

The Australian dollar versus the Japanese yen (AUD/JPY) is much more interesting, especially with the Australian dollar holding a significant yield advantage. The Japanese yen is suffering a fresh bout of weakness because the new governor of the Bank of Japan confirmed that he has little interest in tightening policy from ultra low rates. The double dose of yen weakness and Australian dollar strength hurled AUD/JPY right into overhead resistance at the 200DMA. A rush to the “safety” of the yen in the wake of fresh selling in the U.S.’s regional banks help send AUD/JPY in reverse. Still, while the 200DMA held as resistance, AUD/JPY is now making higher highs and higher lows with the 20DMA in an uptrend. The current 50DMA breakout could hold given this fresh momentum. (Recall that a bullish AUD/JPY has bullish implications for the stock market).

Overall, with the RBA on a path that could include higher rates for some time, I like buying the Australian dollar on dips on the assumption it has likely bottomed against the U.S. dollar and the Japanese yen. I am currently (re)accumulating AUD/JPY on this pullback in anticipation of an eventual retest of 200DMA resistance.

AUD/JPY has traded in a well-defined range all year. The latest uptrend is the latest opportunity to build enough momentum to break out. (Source: TradingView)

Be careful out there!

Full disclosure: long AUD/JPY, long FXA


The Reserve Bank of Australia Looks Ahead to Peak Inflation

The peak inflation narrative has become quite popular with those who look for rapid reversions to the mean. Indeed, the Fed may have broken the back of inflation, even as the June CPI (Consumer Price Index) broke the hopes of peak inflation for one more month. Australia is apparently still climbing the hill toward peak inflation. In its latest statement on monetary policy, the Reserve Bank of Australia (RBA) projected peak inflation later this year. Overall, the RBA’s “central forecast is for CPI inflation to be around 7¾ per cent over 2022, a little above 4 per cent over 2023 and around 3 per cent over 2024.”

The Australian economy remains quite strong. The RBA expects growth this year to hit 3.25% and 1.75% in 2023 and 2024. The slowing growth will not cause a significant boost in unemployment which is currently near 50-year lows. This strength gives the RBA room to continue hiking rates as planned. So it is a wonder that the Australian dollar is not faring better against its major rivals in the Japanese yen (AUD/JPY) and the U.S. dollar (AUD/USD). In particular, the Australian dollar looks like it is topping against the Japanese yen with the often dreaded head and shoulders pattern.

The Australian dollar vs the Japanese yen (AUD/JPY) is looking toppy with a broad, 5-month umbrella from the bearish head and shoulder pattern.

AUD/JPY is just one breakdown below the “neckline” away from confirming the topping pattern. (I almost arbitrarily drew the neckline at the point of the last meaningful, tested support level). In the meantime, I am actually betting on a near-term rebound in AUD/JPY before the head and shoulders pattern resolves itself to the downside or upside. The RBA’s monetary policy is racing ahead of the Bank of Japan, so I interpret the yen’s recent general strength as a counter-trend rally or even some kind of short-covering rally. Time should tell soon.

Full disclosure: long AUD/USD, long AUD/JPY

Low Wage Pressures Suppressing Inflation In Australia

Earlier this week the Reserve Bank of Australia (RBA) released its latest decision on monetary policy. I was surprised to read that inflation remains relatively low in Australia compared to other industrialized countries. From the RBA:

“Inflation has increased in Australia, but it remains lower than in many other countries; in underlying terms, inflation is 2.6 per cent and in headline terms it is 3.5 per cent.”

Seeing that data, I wondered whether the soaring prices of commodity exports and the resulting stronger Australian dollar are helping tamp down inflation. The RBA mentioned neither of these potential drivers. Instead, the central bank fingered low wage pressures:

“Wages growth has picked up, but, at the aggregate level, is only around the relatively low rates prevailing before the pandemic…Inflation has picked up and a further increase is expected, but growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target. “

This sluggish wage growth is giving the RBA the luxury of standing still on monetary policy. The statement gave no hint of a specific time horizon for tightening rates. The RBA is waiting for “…evidence that inflation is sustainably within the 2 to 3 per cent target range before it increases interest rates.” In other words, wage growth is so slow that there are risks to the downside for inflation.

The Australian dollar reacted well in advance of and following the statement. A larger sell-off in financial markets the next two days reversed all the gains for AUD/USD.

The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.
The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.

Be careful out there!
Full disclosure: short AUD/USD

Inflation May Be Dead, But Inflation Watch Is Not

Things have been pretty quiet around here. Every now and then I see a story about rising prices somewhere in the world and think the story would make a great quick post for Inflation Watch. However, I usually do not feel the same sense of urgency I had from 2008 through about 2011 when I felt that rapid inflation was the imminent result of extremely accomodative monetary policy. Everywhere I look, commodities continue to decline in price. Most commodities reached a peak in 2011 and that peak of course had me convinced more than ever that inflation was soon to be a big problem.

Now, thanks to a friend, I am ever closer to accepting that inflation may not be a problem for an even longer time than I expected. He sent me a link to an article called “The Fed won’t taper as long as inflation is low” (by Rex Nutting at MarketWatch) that makes the convincing case that not only is inflation low, but the Federal Reserve has so far seemed powerless to generate the inflation it wants. (I recognize the limitations of government data on inflation, but I do not subscribe to theories that they are concocted specifically to hide true inflation). Incredibly, core inflation is apparently at its lowest point since 1959 (the core PCE price index):

Rex Nutting uses this graph to make the point that all the Fed's QE have failed to go reflate according to the Fed's goals

Rex Nutting uses this graph to make the point that all the Fed’s QE have failed to go reflate according to the Fed’s goals

Nutting also links to a paper from the Federal Reserve Bank of New York called “Drilling Down into Core Inflation: Goods versus Services.” In this paper, authors M. Henry Linder, Richard Peach, and Robert Rich demonstrate that more accurate inflation forecasts come from breaking out CPI into a services and a goods component. Nutting uses this as reference for the claim that the Fed is failing because of global disinflation. This global disinflation is responsible for a decline in the prices of the goods component. Services inflation is much more sensitive to domestic forces (we all know about skyrocketing healthcare and education costs). However, I am not sure where housing sits on this spectrum. It seems to provide a crossroad of forces given housing is not tradeable but foreigners are certainly free to overwhelm a housing market with cash. Foreign demand is reportedly helping to drive up housing prices in some of America’s hottest housing markets like in California and some parts of Florida.

All this to say that, for the moment, inflation is all but dead. But “Inflation Watch”, this blog, is NOT dead. I remain vigilant because I believe that when inflation DOES come, the Federal Reserve will either be ill-equipped to handle it and/or unwilling to snip it early for fear of causing a severe economic calamity. I am a gold investor, and I am eager for another chance to invest in the midst of a commodity crash (I am LONG overdue for an update to my framework for investing in commodity crashes/sell-offs).

The chart below from the Reserve Bank of Australia (RBA) shows that commodity prices remain at historically high levels, mostly thanks to rapacious demand from China. The current relative decline is what is helping to drive goods inflation down. The 2011 peak was well above the pre-crisis peak where prices have fallen now. Also note that prices are much more volatile. I suggest that this chart should remind us that commodity prices are a tinder box that can flare up at anytime. Aggressive rate-cutting by the RBA should also help keep prices aloft.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

So stay tuned. Just when everyone finally concludes that the world has reached a golden age of disinflation where surpluses abound across the planet…that could be the exact moment the tide turns.

Be careful out there!

Full disclosure: long GLD

Australian mining companies struggle with higher labor costs

Australia’s mining sector has done extremely well, largely from exports to a rapidly growing China, especially for commodities like iron ore and coal. This rising wealth helped Australia emerge from recession earlier than most other developed economies and prodded the Reserve Bank of Australia to hike interest rates multiple times.

This amazing growth has come with costs, primarily in the form of higher labor costs. In “Lovesick Miners Raise Costs for Rio, BHP,” Bloomberg describes how the isolation of work in the remote mining areas makes these jobs very unattractive. Mining companies like BHP Biliton (BHP) and Rio Tinto (RIO) not only have to pay extremely high wages as compensation, but they also must include other perks to help miners deal with the isolation. For example, work schedules for miners can include extended trips to major cities in between extended shifts. Still, major shortages of labor exist in many skills. Australia will likely need to rely more and more on foreign workers to do these jobs – the isolation THOSE workers will feel will likely be many times what Australian miners feel. So, this dynamic will be important to watch.

Overall, this article is a fascinating look into the lives of Australian miners and how their work impacts their ability to gain and maintain relationships.

Wages in Australia Continue to Rise Strongly

In “Australia Boom Pays Men Without Degree More Than Bernanke“, Bloomberg uses a gimmicky title to call attention to the tremendous gains in Australian wages during the current boom in commodities:

“Wages grew 3.9 percent in the three months through December from a year earlier, the fastest pace since the first quarter of 2009, according to government figures. When the central bank decided March 1 to keep its official cash rate at 4.75 percent, it said wage growth had returned to levels reached before a 2009 decline.”

Bloomberg also reports that Australian unions are seizing this opportunity to press for higher wages:

“The Construction, Forestry, Mining and Energy Union, Australia’s biggest in the building industry, sought pay increases in February of as much as 24 percent over four years. The Communications, Electrical and Plumbers Union is seeking annual pay rises of 5 percent over the next three years, almost double the inflation rate.”

The article speculates that tight labor conditions and rising wages could place additional pressure on the Reserve Bank of Australia to restart its rate-hiking campaign. Such speculation could explain the Australian dollar’s rapid rise to new all-time highs against the U.S. dollar.

Australian dollar makes new all-time highs against the U.S. dollar

Australian dollar makes new all-time highs against the U.S. dollar

Source: charts

Disclosure: author is long FXA (Rydex Currency Shares Australian Dollar Trust ETF)

Reserve Bank of Australia tightens proactively to fight unwanted inflation

The economy in Australia continues to perform extremely well…so well, that the Reserve Bank of Australia (RBA) now feels compelled to take proactive steps to ward off higher than desired inflation risks:

“…the moderation in inflation that has been under way for the past two years is probably now close to ending…the economy is now subject to a large expansionary shock from the high terms of trade and has relatively modest amounts of spare capacity. Looking ahead, notwithstanding recent good results on inflation, the risk of inflation rising again over the medium term remains. At today’s meeting, the Board concluded that the balance of risks had shifted to the point where an early, modest tightening of monetary policy was prudent.”

Australia’s terms of trade are now around 60 year highs. The RBA also felt free to act given its assessment that “…concerns about the possibility of a larger than expected slowing in Chinese growth have lessened recently…The turmoil in financial markets earlier in the year has abated, though sentiment remains fragile.”

After holding interest rates steady for many months, it seems the RBA is getting ready for a series of fresh tightenings to maintain a lid on inflation pressures.

(Note: author owns FXA, the Rydex CurrencyShares Australian Dollar Trust ETF)