Does this mean more RBA interest rate cuts?

The market’s recent rally has taken a lot of investors by surprise.

After a sharp fall earlier in 2016 – the worst start to a new year in history – the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has shot higher.

It’s up almost 10% over the last month, and 5.7% since the beginning of March.

It’s also acted as a timely reminder as to why it’s important to think about the long-term rather than focus on any short-term market noise.

After all, those investors who sold out at the bottom have missed out on a strong rebound, and that trend could be set to continue over the coming months.

Soaring commodity prices have played a huge role in the recent rally.

Oil is back from the brink while virtually no one expected iron ore to trade above US$50 a tonne anytime soon.

But low and behold, there it was above US$60 a tonne on Tuesday.

It experienced its strongest single-day rise since at least 2008, surging 18.6% higher to US$63.75 on the day, according to The Metal Bulletin.

Now, the metal has lost some of its steam in the time since…

It fell 0.2% on Tuesday night, and another 8.8% on Wednesday, giving investors something of a reality check.

Still, companies like BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) have benefited, and investors seem pretty happy.

After all, the ASX 200 has now risen in seven of the last eight sessions.

Not too shabby considering all the noise in the markets right now!

But while a rising iron ore price is great for those miners, there is one factor that is reversing some of those benefits…

A Rampaging Australian Dollar

The Australian dollar rallied above US 75 cents overnight.

It was the first time that has happened since July 2015, and compares to a low of just US 68.28 cents in January.

The Australian currency is known as a ‘commodity currency’, which means it is heavily linked to commodity prices and exports.

Thus, one of the major catalysts behind the rally has been the strength in the iron ore price.

A higher Australian dollar might be good for cashed-up families looking to go on a long-awaited overseas holiday, but it’s not so good for the miners and other exporters.

Not only can it make their goods appear less appealing to overseas buyers (who may be able to buy the same or similar products from other countries), it also weakens their revenues and earnings in Australian-dollar terms.

That’s not so good for shareholders, nor is it good for the Federal Government which is desperately trying to reduce the country’s deficit.

With the dollar now trading 10% higher than it was near the beginning of the year, the Reserve Bank of Australia has some serious thinking to do…

Now, the RBA has been pretty quiet on the currency front at its recent meetings.

But the latest rally could put the dollar back on the agenda in the near future – particularly if it keeps rising against the US greenback.

According to The Sydney Morning Herald, analysts at Westpac Banking Corp  (ASX: WBC) think that could happen…

They think it will rise another 2.5% or so to US 77 cents.

In an even bolder claim, The Australian Financial Review says that Saxo Bank’s chief economist, Steen Jakobsen, thinks it could trade at parity with the greenback in the future.

How? He suggests the RBA will hike interest rates

Here’s why that won’t happen…

The RBA fought hard to depreciate the Australian dollar.

After spending a number of years above parity, it was necessary to weaken the currency to make our exports more competitive on a global basis – particularly given the winding-down of the mining boom.

The RBA’s long-stated target was US 75 cents, and that was achieved through “jawboning” and a series of interest rate cuts in more recent years.

The chart from the RBA below shows movements in the cash rate, with a particularly sharp fall since around 2011.

TS 10 march

Source: RBA

But interest rates at 2% may not be enough to keep it below that level for much longer.

After all, countries all around the world are cutting their own interest rates and driving the value of their currencies lower as well.

The Bank of Japan, for instance, has recently cut its interest rates into negative territory, joining a number of other central banks around the world in doing so.

This complicates matters for the RBA, with RBA board member John Edwards reportedly targeting a level at about US 65 cents.

That’s more than 13% below its current level…

Here’s something from RBA deputy Philip Lowe, as quoted by The Australian recently…

“The monetary easing abroad is a complication for us, as it tends to put downward pressure on the currencies where the easing is taking place and thus upward pressure on the Australian dollar.”

He also noted that the RBA expects further easing from abroad.

Where to from here?

On the one hand, the RBA doesn’t want to cut interest rates any further.

For starters, it sees it as necessary to have leeway to ease monetary policy in the future if conditions worsen considerably.

It also doesn’t want to add any more fuel to the property boom, although that does appear to have lost some steam recently which gives the RBA that little bit of extra flexibility.

Regardless, a growing number of economists think the Reserve Bank will have to cut interest rates below their current level, possibly to 1.75% or even 1.5%.

If the dollar holds at its current level, or if it keeps on rising, the RBA may be left with no other choice.

Indeed, savers are already having a tough time making a decent return on any cash they’ve stashed in the bank.

In fact, by the time taxes and inflation eat away at the returns, there’s a good chance those individuals are actually losing money by doing so.

If interest rates fall any further, which is entirely possible, the situation is only going to get worse for them.

The Appeal of Dividend Stocks

Shareholders of some of Australia’s best dividend stocks, on the other hand, have been eagerly awaiting further easing in monetary policy ever since May 2015, when the cash rate was cut from 2.25%.

Should that happen, companies like Telstra Corporation Ltd (ASX: TLS) and Wesfarmers Ltd (ASX: WES) could be in hot demand.

So too could a number of growth companies such as Retail Food Group Limited (ASX: RFG), which also offers a solid, fully franked dividend.

Regardless of whether or not that happens however, there are a number of reasons why dividend shares are so attractive right now.

To begin with, the S&P/ASX 200 Index is still sitting well below its highs from last year, with a number of shares trading at what seem like very reasonable prices.

As dividend yields have an inverse relationship with share prices, the yields on offer have improved considerably over the last 12 months, giving investors a fantastic opportunity to load up.

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