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Money market and foreign exchange

Updated: Feb 21, 2022

Economic uncertainty doesn’t kill economists, although it does mean they get less sleep. Over the past twenty-five years alone there has been the Asian Crisis, September 11, the GFC and the European debt crisis. But nothing comes close to COVID-19. Many analysts have spoken about the risks of a pandemic. But they are very hard to forecast. And it is even harder to forecast that Governments (willingly) would shut down the economy to fight the virus (and rightly so).

Given the level of uncertainty, there is no surprise then that there have been big moves in financial markets. Below is some commentary on what it has meant for interest rates and the $A.

Money market

The cash rate has been reduced twice this year, taking it to an all-time low of 0.25%. The last of these rate reductions took place in mid-March, an indication of the concern that the RBA (and the wider community) had at that time about the economic outlook. Subsequently, the economy went into partial lockdown. Consumer and business confidence was at a very low ebb at the start of April.

But the news since early April has been good. The number of new cases fell a lot quicker than anyone thought possible. This has allowed the economy to open up earlier than even the most optimistic predictions. Economic activity is recovering. Petrol tanks are being filled up. Spending on shoes is rising. There is no doubt that recorded economic growth for H1 2020 will be weak. But it likely will turn out to be stronger than what the more pessimistic forecasters were thinking a few weeks ago.

Financial market attention is turning to what the new ‘normal’ will be for the economy. The underutilisation rate (the unemployment rate plus those wanting to work full time) is currently around 20%, so economic activity will need to be pretty strong for a decent period of time before we can provide all the full-time jobs to people who want one. No economist expects the unemployment rate to get back to 6% until before the end of 2021 (it was 5.2% in March). It is then understandable that the RBA does not expect inflation to return to 2% until the second half of next year.

Foreign exchange

Currency markets have been very volatile this year. At the time of writing the $A had fallen by around 5% against the $US since 1 January, although at one time it was down by almost 20%.

The main reason for $A weakness over recent weeks has been the uncertainty about the economic outlook (something that has also impacted the equity market). In tough times investors want quick access to their money, something easier to do in currencies of big economies than those of the small. As economies begin to open up investor confidence has improved leading to lower financial market volatility (albeit it is still elevated). As a result, the currency market focus has returned back to the ‘fundamentals’ and led to the $A trading higher.

Things are starting to settle down and there is growing hope for the future. If that continues, investors should prepare for a stronger $A and (eventually) some rise in interest rates. But we won’t know how much scarring the economy has received from the shutdown for at least another 3-6 months. And a complete return to normal is unlikely until an effective treatment or vaccine is found and distributed. And that is at least 12 months away.

Original post by Bank of Queensland



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