Australia: The safe haven

At various times over the past year, Deus Forex Machina (who is on holidays) and I have argued that the Australia safe haven meme that has dogged discussion of the Australian dollar this year is overblown. Recent months have born that out with the dollar acting as it always has, falling as global risk rose and rising as it declined, the opposite of what you’d expect for a safe haven currency. We previously concluded that there was some sort of rerating going on, which was keeping the currency level higher, but that is far as it goes.

The same cannot be said, however, for Australian sovereign debt. I’ve been trying to write on this for a few days but it appears the AFR has beaten me to the punch (a new experience!), with a good article today:

Fresh warnings of credit rating downgrades in the euro zone have sent ­10-year Australian bond yields to a ­historic low, as investors seek the safety of Australia’s AAA rating and sound fiscal position.

Yields on the 10-year Commonwealth bond hit a record intraday low of 3.78 percentage points yesterday.

Australia has benefited from being a member of the shrinking pool of AAA-rated nations with a stable outlook, increasing the attractiveness of Australian bonds for foreign investors searching for safe havens.

…Australia’s AAA credit rating is highly prized by international investors, who, spooked by the European debt crisis, broadly value safety over yield. However, Australia’s high interest rate environment makes bonds doubly attractive.

Bugger me, even some nice charts! Good stuff.

But, there are a few problems with this analysis which actually leads it to seriously underestimate the power of this move. The last point made about the interest rate environment is wrong. CPI inflation for the September quarter was still running at 3.5%. That means investors are close to giving the Australian government money for free.

On top of that, there’s the point that I started this article with about the dollar, which is not a safe haven. Investors seem happy to park their money with the Australian government despite the large risk that the dollar will take a serious tumble (though of course they are themselves mitigating that risk somewhat through their own purchases). If investors are separately hedging, which, frankly, they’re mad if they’re not, that will add further cost to the transaction, enough surely, to push the return negative.

Finally, there are the ongoing strains in private sector credit and the housing market upon which it depends, around which there is still great uncertainty. If the banks cannot roll over their offshore borrowing in 2012, then in my view it’s simply a matter of time before the government will be forced to renew the guarantee of private debt, creating a new raft of contingent liabilities even as surplus dreams evaporate.

Clearly, however, in a world dominated by the huge risks of a European disintegration, none of these are enough to deter the rush for Australian bonds. We might call this a bubble. But what’s the point? Everything right now is either a desperately deflating or inflating bubble.

The final irony, of course, is that we can’t afford to spend any of this free money. Still, sooner us than them!