Transcript of Question & Answer Session FX Markets Around the Turn of the Year

That's excellent. Okay. Thank you. So, Chris, Karl and Kim, we've got quite a few questions coming through in a number of different ways. Some people have emailed them to us, others have put them in the chat, others have put them in the Q and A. So I'll try and get through these as much as I can.

One thing I was going to ask first is that Chris talked about financing flows, and obviously there's an effect from not having so many US offshore bond issuances, but at the same time the currency has increased. Is this a trade question? Maybe, Kim, you want to give me some feel to, is this trade that's doing this, or is it actually financing flows?

We're seeing the trade side of things having a really big impact on the currency at the moment. As Christopher Kent said, you look at what iron ore prices have done in the last few months, they're up around 40 per cent. Given that commodity prices, in our view, are worth twice what interest rate differentials are, and that's a very hard wave to be moving against. So while commodity prices remain elevated, we think that will continue to underpin the Aussie dollar.

Excellent. Thank you for that. Karl, anything you wanted to add there?

I think that you do have some balance sheet mismatches growing, and that's certainly something that I think the RBA's efforts are going to be helpful in reducing and in so doing reduce some of that stress that we might suffer in a sell-off episode going forward.

Thank you, Karl. I asked you two the questions first, because the next few are going to be for Chris, if that's okay with you, Christopher?

Yeah. Sure.

So, I'm getting a lot of questions here about the balance sheet for the Reserve Bank. Some people are commenting on how the exchange settlement balances have surged. Others talking about how there's a lot of purchases of bonds in the market, particularly in the 5-8 year maturities. Is there a message for markets that you want to make sure that the market is well supported?

Well, we've talked about this in other products, and for some time now, and in terms of the Aussie dollar liquidity that I referred to in my speech, and that's reflected in very high ES balances. Those are the balances that banks hold in their accounts with the RBA.

That's a natural outcome, at least for the system as a whole, of all the various policy measures. When banks take up the offer of the low funding for three year fixed term through the TFF, that leads to higher balances in the banking systems account. One way or another, when we buy bonds in the secondary market, government bonds, AGS and semis, again, ultimately that leads to higher balances in their account.

Those balances aren't a target, so to speak, they're more an outcome and a reflection of all these other policies and the aim of these policies is to keep interest rates low and to provide plenty of low-cost funding for the banks so that they can pass that on to their borrowers, households, and businesses, and that's happening.

And, clearly, we've talked about how trade has, and commodity prices in particular, have kept the Australian dollar reasonably high. What would be the effect of the purchases and the quantitative easing that's taken place on the Aussie dollar if that situation wasn't there?

I tried to cover that in my speech, but it's worth restating, and my remarks addressed this. If you just looked at history, and said how much does the Aussie dollar typically go up when commodity prices go up, as much as they have, let's say, I took the example, since November? That's a significant increase in Australia's terms of trade and typically that leads to a sizeable increase in the Aussie dollar.

Now, it has gone up, but the point I tried to make is, it's gone up by about 5 percentage points less than we would have otherwise thought. Now, you can attribute that to a range of different things, and I would assert that a significant part of that is due to our policies, including the bond purchase program.

Because, remember, many advanced economies have been pursuing QE in one form or another, and we started that through the bond purchase program in November, and that's a significant change, meaning the Aussie dollar is lower than otherwise. Yes, it's appreciated, but we would argue it would have appreciated much more based just on commodity prices.

Excellent. Kim, Karl, any comments you'd like to make further on that one?

I think the only thing I would add to that is that we did a little bit of research looking at how the Aussie dollar reacts to changes in interest rate differentials between Australia and the US, and we did find that the Aussie dollar tends to be more vulnerable to falling when Australian, US, 10 year interest rate differentials are negative. So, again, by having this QE program, it does suggest that the Aussie dollar has been, and is lower, than it would have otherwise been the case without the QE and if it was just being driven by commodity prices.

I would echo that the interesting thing here is the extent to which the RBA may be blazing a path for other major central banks in engaging in YCC and, I guess, soft currency intervention strategies, whether that is eventually echoed by the other commodity linked currency central banks, it seems quite likely. And the question, I guess, in the years ahead is, how much, I guess, effectiveness the RBA strategies are going to have in holding the Aussie down, if we see everyone else playing off the same playbook.

Thank you. And, Karl, I might stay with you for a moment. There's a question here about, do you feel that monetary policy is now exhausted and the fiscal policy has to follow it? Is that something that you think will happen in economies around the world?

Yes. I think there has been a very firm handoff of the baton. Central banks have essentially moved to the sidelines and are keeping policies steady. The interesting thing is that that also sets the foundation in place for a lot of currency volatility at some point.

If we look at the old idea of the Triffin dilemma, we may be in a situation in which the only thing that can move is the FX rate. If fiscal policy and monetary policy frameworks are working in lockstep across the advanced economies, we could see dislocations emerging in the FX markets as a result.

Excellent. Chris, any comments you'd like to make on that one?

I would just add that in terms of monetary policy, I'd just remind people that, through keeping rates low, by providing very clear forward guidance, that the cash rate target's not going to be increased until we see that inflation is sustainably in that 2-3% range. Then backing that up with things like the yield target and the bond purchase program. I would argue that monetary policy is continuing to provide a bit of support. And that's going to be important particularly to help provide amongst other things, the banking system with low cost funding, so that when business demand picks up for that funding and business investment picks up, they'll be well-placed, the banks, to provide that.

The other thing is, and you suggested this Eric, there is a key role and there has been a key role for fiscal policy. There's been plenty of space for that in Australia and that has been being used very significantly, both at a federal and a state level and that's a very welcome thing.

I agree. Kim, any comments you'd like to make there?

For me, the only thing I would add and it's in line with everything else is that the unique nature of this pandemic has meant that there was a space for fiscal policy to fill very quickly because it wasn't a matter of, at the beginning to try and bolster demand because demand couldn't do anything. The shops were shut. You couldn't spend the money, even if you wanted to spend the money. That's where fiscal stimulus did play a really important role and just keeping those businesses, at least on ice, as much as they could until some of those restrictions were able to be lifted. It's been a strange world watching almost a government driven recession and how fiscal stimulus has had to play a very big role. It really is because of government regulation that businesses have found themselves in the position that they were.

Fair enough. One of the questions that I think that is very interesting given that, Chris you've made it very clear that monetary policy is set where it is until inflation emerges. Where's it going to emerge from? Perhaps Kim, Karl, where do you think inflation might emerge from?

I think in the near term we are likely to see at least an initial wave of inflation that's going to be driven by demand-pull inflation as those restrictions are eased, as there is still some pent-up demand that people just can't spend at the moment because they can't travel overseas. They can't do a whole lot of … it's hard to go to the movies, the list is endless. But as we've been monitoring the Australian economy, there is a big sum of household savings that are sitting there that can be spent once restrictions are eased.

We do think there'll be a sort of wave of inflation but the question is still whether or not that will be sustained. If you've got economies that are still operating below potential, you've got output gaps, you've got weak labour markets, you don't have much wages inflation, it is hard to see that there'll be a sustained lifted inflation anytime soon.

I would echo all of that. The interesting thing is that the services sector should see a burst of inflation at some point due to a lack of capacity as things come online globally. But the fascinating thing is going to be really whether markets freak out, whether we have repeated panics over inflation this year. I think there's an extent to which markets are preparing for those right now with the understanding that central banks and policymakers are going to look through the sort of transient inflation and look for signs of sustained inflation before anything gets adjusted, but markets are really anticipating this. You are seeing break-evens move in very interesting ways. Essentially the ingredients for some volatility around inflation expectations, as opposed to realised inflation.

That's a really good point because, we do know of course that markets do look beyond what's right in front of us. That suggests that there's going to be this sort of perception that yes, inflation is with us. But obviously there's other factors behind that. Chris, I mean, obviously you're going to be looking for a number of indicators to tell you that things are moving forward and that inflation is back.

Our forecasts, in terms of inflation, what's required is a tight labour market for that to be sustainably within 2-3%, we need a tight labour market to drive wage growth back up again. That's what we would be looking for. Thankfully, the unemployment rate did not get as high as initially feared, that's very welcome but there is still a substantial amount of spare capacity in the economy and a long way for demand to recover.

That recovery is taking place now. But as we've been saying, for some time, we expect it to be a an uneven recovery, and it's going to take some time before we close that output gap, generate sufficient demand to have a tight labour market. But those are the sorts of things we'll be looking for as a precursor to higher inflation, a tighter labour market.

Excellent. Thanks. One of the other things that I think is interesting, we talked a little bit about trade earlier and China has come up a couple of times. Obviously, there's been some shift in some of the commodities that we export to China, those markets apparently not available now. We have the interesting situation, and we talked about this earlier, our wine is suddenly in demand in Britain. When the last time we exported wine to Britain the Aussie was in the 50s, now the Aussie is in the 70s, but somehow, we're exporting wine to Britain. I mean, what's happening with trade? Is it shifting around? Kim, you want to take that one first?

All right. We're obviously watching the developments with China very closely and how it does impact Australia's exports there. One of the things that's still holding up at this stage, but they did allude to the downside risk, are the iron ore exports. That being one of the biggest exports with 80% of Australia's iron ore exposed heading to China, that's the main one that we're watching. We haven't seen that come under fire as of yet.

But it is going to be important to see whether or not Australian exporters can find other markets. For those exports that have been targeted, can they divert that elsewhere? Will they get the same price for that when it's diverted? Those are still a few uncertainties, but I think India still does stand out as a large and a growing economy that could absorb some extra demand if we do see it fall away from China more substantially.

Excellent. Thanks. Karl, any words you could add there?

I love what Kim is saying there. I think that the iron ore situation is an enormous vulnerability, not just in the sense that we've seen such a market rebound here, but that liquidity conditions in China are driving a lot of that. Front-running to some extent, Chinese stimulus efforts is helping to lift demand and increase stockpiling and we could see at some point a correction in that. Whether it's due to a shift in policy in China or a shift in global liquidity conditions, that's tremendously vulnerable.

But I think the one amazing lesson out of all of this has been the extent to which, as you alluded to, global trade flows have been rerouted that we've been able to rapidly adjust to demand shortfall in one area of the globe by rerouting elsewhere and keeping global supplies relatively abundant and consistent. It's certainly surprised a lot of people, and I think in FX markets, very few expected that Australia would sail through this in quite such a robust condition.

Yeah, fair enough. Chris, I have a question here that looks like it's tailor-made for you. If other central banks stop their easing programs in 2022, at the same time the job market still hasn't got near the wage growth that we need, would you be forced to follow, or would you be happy with maintaining current settings?

In the context of a discussion about FX markets, this is a good question because by having a flexible exchange rate regime, we have the flexibility to follow our own path for a good time on monetary policy. So we'll be setting monetary policies here by very much focusing on domestic economic conditions in the outlook and we're going to be looking for, as I suggested, a closing of the output gap, tight labour markets, higher wage growth, and therefore higher inflation that can be sustained. If other central banks are in a position where they're pulling back a little bit, some of the stimulus that they've got out there now, and we don't feel the need to do that because of our economic conditions, presumably, that'll help the Aussie dollar move a bit lower than otherwise, and that's valuable support. But we'll be looking at all those things and most particularly not so much what other central banks are doing, but what's happening domestically in our economy, and what our financial conditions are, and what can we do to support a good recovery here.

Thank you. I was going to ask just one more question. If there are more questions, please post them up. We're more than happy to take them. I guess this is open to everyone, and I understand if you don't want to respond. But what should treasurers, our members, be thinking about now in relation to the currency? What is the thing that they should really be doing now? Karl, do you want to take that one first?

Sure. Yeah, I guess the one thing that I would be focused on at this point is, I guess, diversifying to whatever extent you can. This is a really interesting market that has sort of become bipolar, if we could say it that way. We're in a risk-off/risk-on environment that looks very much like 2009 did. The playbook looks very, very similar. But we're very likely to move through sort of that whole 2009 rebound in an accelerated fashion. And so at some point the party will end to some extent, and it's probably a good idea to be prepared for that.

Kim, anything from you?

I think all I would add from the perspective of the Aussie dollar is that, obviously, our forecasts are relatively muted for a soft rise, compared to where we are by the end of the year, and that might stand out and be quite a contrast from all of the volatility that we saw in the Aussie dollar over 2020. But there's a lot of focus at the moment on the improving global growth outlook, on vaccination programs, on that being the sort of silver bullet to get the economies back on track. But I think it's just worthwhile remembering that there are still downside risks. The balance of risks might be a bit more even than they have been in a while.

But we do still have these COVID variants that are gathering pace in a number of countries. And the global economic recovery is still very much tied to the path of the virus, to the path of vaccination programs, which are incredibly hard; I would say impossible to forecast. So there is still the risk that we do see bouts of volatility of uncertainty of risk-off. So I think FX volatility isn't entirely behind us just yet, even though it does feel like all we're talking about and thinking about at the moment is getting to the other side of this COVID pandemic.

Exactly. Well, Chris, I know that if Guy Debelle was here, he'd say, "Sign up to the FX Global Code." But from your point of view, what would you say to the treasurers?

Well, I would say I'm not in the business of providing financial advice.

Very good.

With that caveat in mind, the other thing I'd say is I'm also not in the business of forecasting the exchange rate. I would say our best forecast of the exchange rates is the current rate. Having said that, if you're going to lose sleep over what might happen in foreign exchange markets, well, I was taught many years ago, "Do what you can, and there's plenty of opportunities to diversify and hedge that risk." But I don't think I'm telling your members anything that they don't already know there.

No. Look, that's fine. Thank you very much for that. They are very good words. And one of the things of course is that if you do try to forecast, if you try to anticipate everything or think that it's going in one way, then you can almost guarantee it's going to go in the other. So it's always good to be prepared. And I think one thing that we do know is that, despite the rule of thumb that the Aussie goes through that sort of 10% change every year, we've just seen it go through 20, and it's happened before. So it can move very quickly and, obviously, people have to be well prepared for that.

Okay. I do have one more in here; a couple actually. There's one from James Glynn. In the absence of RBA's QE program, where do you think the Australian dollar would be trading today? And do you expect the currency's recent uptrend to remain in place? Good question.

Let's guess where it would be. I do think around 83 cents based on our modelling. Given where commodity prices are, given where growth differentials are, interest rate differentials, we would be three or four cents higher than where we are today. But overall, whether that uptrend remains in place is going to be very dependent on the factors that Kim suggested, and I don't think that the legs are there for a 10-cent swing this year upward. The risks are turning to the downside; put it that way.

Kim or Chris, anything from you?

Yeah, I would just agree with that. I think our fair value model as I've mentioned in my presentation, it's centred at around 82 US cents right now. So it feels like it's as good as any point on the map to hit. But with the outlook for commodity prices to come off over the second half of the year, just as that Chinese stimulus effect starts to fade, I'd suggest the Aussie is not likely to get there and not likely to sustain and move up there. So we still think that sort of high seventies as where we'll be mostly for this year.

Lindesay, I would just reiterate what I said earlier in my opening remarks. I'm not going to predict the future, but in terms of recent months, something in the order of 5% is the extent to which the Aussie dollar is lower than commodity prices by themselves would have suggested. Now how much of that's monetary policy? No one knows for sure, but I would assert that a good share of that is associated with a bond purchase program and the other measures that we have in place.

Absolutely. I agree with that. Another one that's just come up is an interesting one, which is with the volume of purchases the RBA has been doing, and this is very much one view, Chris, is there a risk of crowding out some of the banks who need the debt for regulatory reasons? Is that a risk or is that something you want to avoid?

Well, of course, the objective of the bond purchase program is to crowd out someone's holding of those assets. Our intention is for us to hold them and by doing so, push those yields lower than they otherwise would be and help to generate that portfolio balance sheet effect, which can help to weigh on the currency. I think that's happening. Is there a risk that the banks don't have enough access to these instruments? Well, we're certainly conscious of wanting to think about market conditions and we don't want to be a source of market dysfunction where markets are unnecessarily tight. I don't think that's the case at the moment and I don't think that's in prospect. And I would remind people, of course, if a bank was to sell us a bond that they hold, not just sell it to us as an agent for somebody else, but their own bond that they were holding in our auctions well they're receiving cash and that's the most liquid instrument you can hope for.

Absolutely. Thank you for that. Finally, we can't get away without asking the GameStop question. What about equity market valuations and excess liquidity and meme stocks? Is there a risk that Australia has an equity market, which is just bumbling along too much? Anyone want to take that one?

Oh, okay. I'll jump into that, I guess. Yes. Certainly, there is risk, but I didn't think that it is localised risk at this point. Markets are anticipating or are trading on the right things, the improvement in global fundamentals, improving prospect for productivity, improving demographics, even all sorts of great factors are playing into global equity valuations. But there is unquestionably frothy activity in certain sectors and certain instruments. And so I do think that if we're talking to average householders or to businesses in general to urge everyone to stick to their knitting and to stick to those long-term investment plans. It's very concerning right now just see the FOMO complex kicking in. I did three interviews earlier today on cryptocurrency. The last time that I did so many interviews on cryptocurrency was the literal day that Bitcoin peaked back in 2017. And so I would suggest that there are some very contrarian indicators out there right now and it's clearly going into excessive overdrive. I'd be worried about what happens after it's all over.

Absolutely. Kim, from your point of view?

I have to pass this one off to Christopher Kent. I'm not an equities analyst. So, sorry.

I can't add too much to what Karl's saying. I guess I'd just observe a couple of facts. Firstly, unlike some other markets offshore in terms of our equity market, the overall index is not above its previous peak early last year. That's the first thing. It doesn't mean the equity market is not without risk. It always is. That's the whole point of the equity market in many regards. The other thing is, if you look at some other measures of valuation, the equity risk premium, and there are many different versions of this, but for what they're worth, that's not that out of line with recent years. It's chopped around a bit through the year. But at the moment, it's not that divergent, which is partly saying people recognise there's a risk to earnings and earnings have been hurt by the pandemic, that's for sure. But valuations are being helped by very low interest rates globally and people have absorbed that message.

Thank you very much. Well, I'd just like to thank Karl, Kim, and Chris for their answers here today and for taking all these questions.