The markets are designed to wrong-foot everyone, as often as possible, including me, you and Meghan Markle. We can see it playing out in the gold market right now.
Bloomberg reports speculators were shorting gold at their highest level since 2006 recently. And what’s happened since? Gold rallies!
That’s a nasty place to be in for those betting against gold. If the price keeps rallying, they’ll get hit by a short squeeze. That’s where traders buy back their positions to get out of the market, fuelling the price even higher.
That’s playing out in the US futures market.
But it’s also working in the favour of Aussie gold producers. The Aussie dollar gold price is back above AU$1700.
It’s a good example of the tailwind that commodity producers here are getting from the weaker currency.
What interests me today is iron ore. It’s trading at US$72. It’s been holding around this level for a long time now.
Here’s why I think it matters (and it’s nothing to do with mining)…
Australia’s Triple-A rating: more important than ever
It matters for the government, which in turn matters for the major Australian banks.
Here’s what’s happening.
The volume and price of Australia’s iron ore exports are good, relative to the expectations of where they would be in, say, 2016.
With the Aussie economy ticking over relatively well and the mineral industry strong, tax receipts are coming in much better than expected.
The federal government is within range to be in surplus this financial year.
This is vitally important to help keep the funding costs for the Australian banks low. That plays out for mortgage rates, and therefore the health of the Aussie consumer.
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I don’t hear anyone else talking about this point.
Here’s the back story.
The banking system funded the property boom through a massive expansion of credit. Banks do not lend deposits, but they do need to ‘fund’ their lending. The Aussie banks did a lot of this offshore.
Most of Australia’s massive external debt is related to the banks. They borrow this money in the international ‘wholesale’ market. This is where the big guys trade huge amounts of cash.
The credit risk of the banks, and the price they pay, is related to the Aussie government’s ability to bail them out if they run into trouble. The Triple-A rating of the government matters.
The big four are viewed as state-backed, rightly or wrongly.
If the federal government’s rating goes down, then the banks’ ratings go down and the interest they pay goes up. Mortgage rates would rise under this scenario and the Reserve Bank can’t do jack about it.
The credit ratings had the Australian government on a watch for a potential downgrade in 2016 and early 2017.
Now, with this federal budget pressure easing, Australia’s Triple-A rating is more secure. This should keep funding costs lower than they otherwise might have been. The big banks are also cutting what they pay on deposits to lower their domestic costs.
However, nothing is clear-cut here. Australia’s Triple-A rating is a help, but there are many variables at play.
The Fed is raising short-term rates in the US. Aussie banks bid in this market.
In fact, the US credit scene is probably the most important market in the world right now…
Party goes on until this switch gets flicked
That’s not just for the banks here, but equities the world over.
Right now, the cost to issue corporate debt in the USA is still relatively cheap.
And there’s plenty of it. This week, my colleague Porter Stansberry showed that it’s up by US$2.5 trillion since 2008. This debt level, relative to GDP, is the largest in American history.
This is part of the fuel behind both economic growth and the mammoth stock buybacks happening in US stocks right now.
Porter makes the following point: A lot of this debt is going to get downgraded when some of the shaky finances behind these firms get exposed. Higher interest rates are going to do that at some point.
That will send the cost of rolling over any borrowed funds even higher.
It’s not something to worry about today…but bears careful watching.
The spread between junk bonds and US Treasuries remains narrow as of now. While this continues, credit markets should remain benign, all else being equal.
This will play out in equity markets.
The US stock market is likely to keep rising until this dynamic changes.
It also helps the Aussie banks keep their financing costs down.
However, looking a little further out, conditions may not remain quite so benign.
As the Bible says, the ‘borrower is servant to the lender’.
Right now, be positive for 2018. Be a little cautious in 2019. And keep a very sharp eye on credit markets in 2020.