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Analyst report - forex
Hitchhiking on the carry trade
November 7, 2007
Brendon Lau, ShareAnalysis
When reading about the high Australian dollar, you will likely hear about the "carry trade". The carry trade is an important factor pushing our dollar to 23-year highs. Understanding what the carry trade is will give you a better appreciation of the drivers that are keeping our dollar at lofty levels.
The carry trade is the process where investors borrow money in countries with low interest rates to buy assets in countries offering higher interest rates. Traditionally, the carry trade has been between the Japanese and US currencies. For more than a decade, investors have been borrowing Japanese yen and converting it to US dollars to buy US Treasury bonds, securities and other assets benchmarked against the US interest rate.
Up until recently, this has been a relatively reliable way to make money, as interest rates in Japan have stayed at zero for many years (it is currently 0.5%) as the country struggled with deflation.
Interestingly, basic economics tells us that the carry trade should not generate reliable returns, as any gains from the interest rate differential would be wiped out by the corresponding rise and fall in the respective currencies.
This has not happened before because the carry trade weakened the yen as investors sold off the Japanese currency to convert it to US dollars. In more recent times, the carry trade has gained popularity with other high-yielding currencies like the Australian dollar. The global carry trade has helped fuel an era of cheap debt, which has led to criticisms about the mispricing of risk.
However, the day of reckoning could be upon the US$/yen carry trade. The US sub-prime meltdown sent shivers down investors' spines, which has led to panic-selling of US and global assets as investors rush to repay their yen-denominated debt. This sudden unwinding of the US$/yen carry trade and withdrawal of capital have led to a liquidity squeeze in global financial markets. With the US economy threatening to slip into a recession and the prospect of more interest rate cuts, it is unlikely investors will be returning to this carry trade in large numbers for a while.
This does not mean that all carry trades might fizzle out, though. As interest rates in Japan are expected to stay low for the foreseeable future, fundamentally, nothing has changed for the global carry trade. In fact, problems in the US could push more carry trade activity our way once the bout of risk aversion dies down, especially since there are expectations that Australian interest rates will head up as our economy powers along, thanks largely to the commodities boom. If this transpires, it will keep the Australian dollar flying high.
Our dollar is not the only one to benefit from the resource boom. The Canadian dollar has jumped to parity against the US dollar. Canada and Australia are big exporters of commodities and the threat to both currencies might come from falling base metal prices. However, the Australian dollar could have an edge over its Canadian counterpart - Australia is far more insulated from the turmoil rocking the US economy.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this week's CompareShares newsletter:
Economics: Wolf, wolf!
Rates outlook: RBA to raise rates to 7.0% at one of the next two meetings
Rates: RBA ups interest rates to 11-year high
Rate rise impact: Households 'should rethink budgets'
Trading: Buy the rumour, sell the fact
Investing: Why investors shouldn’t trust their own judgement
Forex: Hitchhiking on the carry trade
Commodities: Global commodities bull flexes its muscles
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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