History of the USD - from 1970

Its worth at this point pondering the history of the USD. People talk about currencies as if they are a measure of value, but in fact thats not really the case. There are 3 things that determine the relative value of currencies:

1. The relative value of the base currency its paired with

2. The sustainable value of the currency for trade and investment

3. The short term speculative value of a currency in terms of its yield

Any class of asset that offers liquidity like the forex market can be traded successfully. So looking at the USD against the British Pound Sterling (GBP) we can see that the USD was strong in the early 1970s on the back of strong economic growth, but as inflationary pressures arose in the late 1970s it fell off considerably. In the early 1980s we have another long rally in the USD as the Fed chairman Paul Voelker aggressively raised interest rates to eradicate inflation. Thereafter there was a period of consolidation which corresponded to pretty goof economic growth in the 1990s. Its noteworthy that the USD was stronger during the brief 2000-1 US recession, but the USD has been weak in the US ever since despite strong US economic growth. This occurred because the Fed reduced interest rates to a record 1%.

There was a brief period of USD strength in 2005-6 as the Fed responded to inflation fears. But from Sept'07 the USD has weakened as the Fed focus has shifted to the weak economy. I frankly am not so confident that the Fed will engage in another period of lower interest rates. I think the market doesn't understand Ben Bernacke's intent. The intent of the Fed will always be to give confidence to the market, and it does that by saying that it will 'drop money from helicopters' to stave off recession or depression. I think the only time a government could do that is during depression or war time. For this reason I think Bernacke will step in and raise interest rates as soon as there are signs that inflation is growing. Since we can't have much faith in the CPI as a measure of inflation, we need to look at other tools, eg. Your shopping basket cost, growth in wages. These are the more reliable trustworthy tools for monitoring inflation because they are price-taker markets.

The problem is that higher interest rates will not eradicate inflation. Inflation is the markets way of correcting an imbalance between the amount of money in the economy and the sustainable level of output. If you expand an economy at such a rate and use debt to finance even faster rates, you can only preserve low inflation as long as speculative asset bubbles are inflating. This process takes pressure off staple prices (because the price increases is borne by asset inflation) and delays wage demands since wage earners are benefiting from stronger property prices and regular work for the family.

Once asset prices fall, there needs to be a corresponding rise in prices to offset the imbalance, as wage earners are now looking for higher wages to restore their purchasing power as prices rise. Inflation keeps rising not because inflation has not been eradicated but because there is still excess money supply in the economy.

I believe in the short run we are looking at a weaker US and global equity markets as Bernacke lowers rates to resuscitate them. I believe he will ultimately be forced to move hard on interest rates as inflationary expectations rise, forcing demand to soften. At that point I think the environment will become a non-issue.

- Andrew Sheldon www.sheldonthinks.com

Dont ride off the NZ economy

I dont see an increase in the NZ overnight cash rate. Dont see 50bp rise, more likely they will hold, with a 15% chance of a 0.25% increase. On the negative side (in favour of rate increase):
1. New Zealanders dont save
2. Need to rein in credit creation in an inflationary setting (ie. real rates are lower)
3. Growing inflationary outcomes worldwide - but not recognised by the Fed
4. Central banks are generally not inclined to make big steps unless they want their impact to resonate. A 0.5% would kill off the economy when there are strengths emerging.
5. New Zealand farmers are already being punished by a strong dollar and rising costs

On the positive side:
1. Previous rate rises are already having an impact
2. The outlook for NZ exports (food in particular) is very good
3. NZ is principally a food exporterYou watch food prices take off over the next few years.
4. The carry trade remains in place
5. Softer global ecoonomy

The good news is that this will restore earnings to farmers who have until now been struggling under low prices, high fuel/fertiliser costs and rising interest rates. I think we will increasingly see the corporatisation of farms globally in this period. The consequence of this will be:
1. Acquisition or merging of farm interests around the world by corporate players for subsequent listing on the stock exchange.
2. Amalgamation of farm holdings under a few very large companies with interests that integrate farming, processing and retailingHopefully farmers will see what is happening and not sell off the farm too cheaply. Fortunately they are already benefiting from an oversupply of credit. But you can expect corporates will pay even more for properties IF they can generate an income.

Why will this happen?
1. Because farm prices have lagged the increases in other commodity prices. Just look at the components of the CRB Index. See www.crbtrader.com.
2. Because its a global trend - towards greater global integration - and it makes particular sense in agriculture because farms are under-capitalised, often lacking the benefits of skilled technical resources, climates are shifting around the world because of the 'natural' heating and redistribution of rainfall.
3. Because where there is money there are investment bankers
4. Because farming is no longer a lifestyle - its a business and deregulation has globalised the agri-market
5. Because the use of farm produce in biofuels will lift demand, along with growing demand for agri-products in emerging markets (eg. China, India) as diets change.
6. Corporate entities want to increase market share
7. Corporate entities are comfortable operating in multiple jurisdictions
8. Corporate entities want to diversify operations to preserve stable earnings as well as offering segmental market focal advantages

The leaders in this process are likely to be:
1. Investment bankers, eg. Rand Merchant Bank, Macquarie Bank, Elders
2. Resource-retailers, eg. Wesfarmers, Woolworths looking for vertical integration
3. Some more wealthy and commrcially astute farmers
4. Existing listed agricuktural companies, eg. Australian Agricultural Co (ASX.AAC), Australian Wheat Board (ASX.AWB), etc.

Its actually interesting to see how events transpire because currently farmers are being squeezed by rising costs, stronger currencies, low prices, and even droughts in some markets. This is why I think we are starting to see take overs of agricultural assets, eg. Namoi Cotton in Australia. Who is next? Dont forget the baby boomers sitting on productive (but small) farms are likely to be considering selling off in preparation for retirement. They will be looking at the relatively high prices for land and saying its too hard, my kids are not interested in farming, its time to sell-up and move to the coast and retire on a waterfront. Farmers looking to expand their interests will be in acquisition mode. Other targets are likely to be farmers reeling from drought, low prices or hedge contracts that went wrong. This is all fertile ground for the investment banker.

So looking at the NZ dollar....we need to consider:
1. Central banks need to control inflation
2. Loss of competitiveness of a strong NZD
3. Weakness of NZD due to a subdued global economy (USD)
4. The seeming intent of the Fed to push for lower interest rates - forcing the hand of the European Central Bank (ECB) to follow suit, or again sustaining the unhealthy US economy
5. Weakness of the NZD if the Japanese carry trade unwinds

I dont see the Reserve Bank of NZ increasing rates at this time....I see it holding current rates. If the ECB follows the Fed, and there is another cycle of easing rates, the NZ will remain strong, undermining any need for a rate rise and the NZD will anyway be supported by stronger exports. If the ECB doesnt follow the Fed, and the Fed waits (as I expect), then we can expect the status quo (thats short term trading conditions...you needing to sell into rallies). Eventually of course inflaiton will unwind the carry trade.

- Andrew Sheldon www.sheldonthinks.com

The $AUD looking at parity with the USD by Jun'08

The AUD has been one of the strongest performing currencies this year, and there is no evidence of that changing soon. In fact there are good reasons why we can expect the AUD (currently at 0.86USD) to reach parity in the next 12 months. This is likely to occur on the back of strong export price settlements next year, which will likely coincide with a rise in the Reserve Bank's rate.
The $A is performing well because of the very favourable terms of trade, as the economy continues to benefit from strong export prices for mineral commodities, as well as an improving outlook for the farm sector. We can expect a breaking in the drought as well as higher global food commodity prices. On the domestic front, production capacity and labour markets are very tight, so there is every likelihood of strong business investment to lift productivity. A number of businesses and state governments have flagged the need for greater infrastructure spending. The long (100 bulk carriers) queues off Newcastle port are a testimony to the shortage of export capacity at Australian coal ports. Housing vacancy rates are also very tight, and whilst interest rate increases can be expected, there are several reasons why a strong AUD will be prompted by positive developments:
1. The stronger AUD will help reduce inflationary pressures - since imported items will be cheaper in AUD terms
2. The stronger will support alot of portfolio investment - particularly in mining and agriculture
3. The high levels of debt will discourage government from lifting interest rates significantly
4. Growth in incomes will fuel a 2nd rally in the property market

- Andrew Sheldon www.sheldonthinks.com