The US finds itself again in a dilemma. The strident risk appetite in the world is keeping the US dollar under pressure. It is being used more as a funding currency, since interest rates in the US are at rock-bottom levels—as low as they are in Japan, if not lower. Further, the weak employment report for September that came out last week, weak Purchasing Managers’ Index and weak orders for durable goods have put paid to any notion of premature tightening of monetary policy in the US.
The contrast between the perceptions of economic strength in other parts of the world and in the US was brought out in sharp relief by the decision of the Reserve Bank of Australia (RBA) to push its policy rate up from 3% to 3.25% last week. Its decision caught many market participants by surprise. The press release that accompanied the rate decision from RBA sounded confident and upbeat about the growth prospects in the country and in the region as well. Thus, it contained hints of further rate increases. Its decision was further vindicated by the rise in full-time employment for September in Australia. Later in the week, Canada joined Australia in releasing a strong set of employment figures for September.
This further fuelled interest in carry-trade (borrowing in a low-interest rate currency and investing in higher-interest rate currencies). Commodity currencies gained further against the dollar, even as investors rotated out of Australian and New Zealand dollars to some extent. The difference in the risk appetite and the pursuit of carry-trade this time around and in 2003-07 is in the lead set by the US then. In those years, the US economy was expanding. Housing was in a boom. Consumers, despite weak employment creation and stagnant incomes, were living off asset price gains and consuming beyond their means. The savings rate plunged. Imports surged and American growth was respectable. The dollar weakened due to the US’ low interest rates compared with rates in other leading economies. But its stock market performed well and stock markets in other countries did even better.
This time around, most of these factors are present but, crucially, US consumers are missing in action. Job prospects are deteriorating and households are busy reducing their debt. Inventories are still being pared back by wholesalers, and holiday season sales are predicted to decline for the second year in a row. Job openings are declining and are yet to bottom out. The real-time business conditions index (Aruoba-Diebold-Scotti) maintained by the Federal Reserve Bank of Philadelphia shows that the improvement in business conditions has run its course, at least for now. This index is based on data up to 8 October. Hence, it is a real-time business conditions index.
Of course, the US stock market has been rising for most of the last seven months. However, given this weak fundamental backdrop, it is not clear if the stock market is leading the way for the rest of the world or is being led by optimism (misplaced or not) about growth prospects elsewhere in the world. The decision by RBA to raise its interest rate would have further fuelled this doubt in the minds of Americans and they would be uncomfortable with its implications for US dominance—it has shrunk in recent times, but it still is the dominant power. They would be anxious to prevent further damage.
It might appear strange to readers to find common ground between Ben Bernanke’s comment that he stood ready to raise interest rates when economic conditions improved and the decision of the Norwegian Nobel Committee to award the Peace Prize to US President Barack Obama. The former was meant to shore up confidence in the US dollar and the latter was aimed at shoring up the US’ standing.
That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable.
Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour.
Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org