Today let's start with the Australian dollar again. We promised to ask around the HQ and see if anyone had ideas on the relationship between the Aussie dollar and the All Ordinaries. Fresh off his 'Extinction Event' report, Murray chimed in. The Slipstream Trader wrote,

'There is not much that I have to say about the Aussie vs the ASX 200. The Aussie seems to be running under its own steam at the moment. I have noticed that a rallying Aussie is not necessarily translating into a rising stock market. But a falling Aussie will often also see equity weakness. Most of the offshore money coming in seems to be heading towards our bonds rather than into equities.

'You can see the high correlation between the Aussie and stocks broke down in mid-2010 when QE2 was announced, although the correlation is back to being fairly high now.

'Both the ASX 200 and the Aussie are in holding patterns, so there is very little predictive power in analysing them together at the moment.'

A Holding Pattern in the Dollar and Stocks

Source: Slipstream Trader

He's probably right. But if we had to hazard a prediction, we'd say a lower Australian dollar will be good for stocks, at least in the short-term. The weaker currency would lower costs for commodity producers. That would take some pressure off profits and soaring capital and operating expenses. More on that in a moment from Santos honcho David Knox.

The Aussie dollar strength is both mysterious and obvious. It's mysterious because in April 2009 the Reserve Bank of Australia moved the cash rate down 25 basis points to 3.00% and left it there for six months. At the time, it took you 83 US cents to buy an Australian dollar. Today, the cash rate is 3.25% but it takes you 104 US cents to buy an Australian dollar.

There you have it. The dollar is up 25% since then WITH lower interest rates. It's obvious, then, that interest rates aren't the key driver of the exchange rate right now. So what is? It's as simple as supply and demand.

Foreign investors purchased $58 billion worth of Commonwealth government bonds in 2012, according to Joanna Heath in yesterday's Australian Financial Review. In dollar terms, that was second behind iron ore exports at $85 billion but ahead of coal at $48 billion. Selling all that debt brought an extra $58 billion into the country, propping up the Australian dollar and inflicting great pain on manufacturers.

At this point, you could have a pretty interesting philosophical discussion about what kind of resource boom you have when government debt is your second biggest cash export. The current government should probably take heart! Here they have evidence that the larger the debt grows, the stronger the Australian dollar gets.

That's Orwellian with a modern twist. In 1984, the world is so upside down that, 'War is Peace, Freedom is Slavery, and Ignorance is Strength.' The financial world is so upside down today that Debt is Prosperity. The more you borrow, the richer you are!

With regard to stocks, though, we wonder what would happen if you took that $58 billion out of the government bond market. Would foreign investors be just as happy to buy BHP Billiton, Telstra, and Westpac? Is that what they'll do if the RBA lowers rates again? Or if the government manages to conjure a surplus?

There's a lot that's unknowable. But we do know that if the Aussie dollar were lower, business costs in Australia would be more manageable. 'Costs in Australia are extremely high, and it is a concern to both oil and gas companies,' Santos CEO David Knox told the ABC's Inside Business on Sunday. 'I know it's also a concern for minister Ferguson (Resources and Energy Minister Martin Ferguson) about these costs...We are going to have to bring our cost base down and that's the critical thing that we are all committed to working on.'

Of course the big risk is that a weaker Australian dollar spurs capital flight; foreign investors head for the door. And growing debt at the State level might contribute to that exodus. For example, Moody's changed its outlook on Queensland from 'stable' to 'negative' yesterday. It cited that state's high infrastructure costs and deteriorating fiscal picture. Queensland's state debt is 130% of state revenues.

Queensland didn't actually get downgraded. But today, Standard and Poor's said that both Victoria and New South Wales could see their credit ratings come under pressure too. It's pretty simple. Revenue (mining royalties and stamp duty mainly) are either not growing as fast or are threatened, while expenses (infrastructure) are growing.

For investors, there's a lot going on here. Government borrowing from foreigners gets more expensive as interest rates rise. This is one reason we're certain the powers that be back the inclusion of fixed income securities into superannuation. If you direct some of that compulsory superannuation money at government bonds, you lessen the risk of relying on foreign capital.

That's a small opportunity in itself (the bond ETFs that we've recommended in The Denning Report being the way to play it). But it also highlights a more important point: quality businesses are far more intriguing long-term investments. A business that grows revenues is in a stronger position than any entity which must raise taxes to pay bondholders.

Not just any business will do, of course. You need a business that can reliably grow revenues over time without having to borrow a lot of money.

Which brings us back to Santos. Australia's conventional and unconventional natural gas is not just for export to Asia!

Knox also made that point in his Sunday interview. He said by 2017, Santos will invest some $800 million to revamp the infrastructure at its Moomba facility in the Cooper Basin. He expects that to bring down domestic natural gas prices in Australia, and to increase the use of natural gas in Australian industry and power generation.

This would basically follow the North American shale gas model, which is why we pay attention to Santos. It's the obvious blue-chip play on on-shore natural gas in Australia. But we reckon speculators can make a lot more money on the exploration stocks in the Cooper Basin, some of which have reliable cash-flow from oil production in the Basin's Western flank.

Our risk here is that energy prices fall in general, or that natural gas never really replaces coal as the preferred fuel for power generation in Australia. After all, Australia DOES have a lot of coal. Why go to the trouble of finding and pumping gas when digging up coal is much easier?

Hmm. Well, you have to take some risks to make a fortune. And the most famous Australian ever took such a risk. By doing so, he literally financed the birth of the oil industry in Persia. You'll hear his story later this week.

Regards,

Dan Denning
for The Daily Reckoning Australia