Australian Dollar Rises Despite Unwinding of Carry Trade

When two weeks ago the Royal Bank of Australia (RBA) cut interest rates, one would have expected the Australian Dollar to suffer proportionately. Instead, the currency continued its steady upward rise, and touched a six-month high, before falling back slightly. One surprised analyst lamented, “These types of inconsistencies can make trading forex difficult or down right frustrating at times.”

The interest rate cut marked the sixth since September, since which point the RBA has trimmed its benchmark lending rate by 425 basis points, leaving it at 3%. [See chart below courtesy of "The Fundamental Analyst."] Traders have reacted to the successive declines in yield and simultaneous pickup in risk aversion by unwinding carry trades, many of which had been long the Australian Dollar. The massive sell-off that ensued left the Aussie a long way below the level of parity with the USD, which only last year many analysts had viewed as inevitable.
The most recent rate cut, in contrast, was greeted positively by traders, perhaps because they were expecting a larger (50 basis point) rate cut, but more likely because their priorities had changed. A pickup in risk aversion in recent weeks has definitely reinvigorated interest in comparatively risky currencies such as the Australian Dollar. Overall, the markets remain risk-averse, and investors are increasingly making bets in accordance with economic fundamentals, rather than yield levels. ” ‘The focus will remain on the global backdrop…Risk appetite is still fragile and the market is increasingly realizing that the recent recovery was excessive.’ ”



In the case of the Australian Dollar, traders were heartened by the RBA’s decision to lower interest rates to a 49-year low since it reflected the Bank’s commitment to dealing with the economic crisis. But at this point, the Australian economy is still in poor shape. “Prime Minister Kevin Rudd said yesterday for the first time that a recession in Australia is inevitable amid a slump in global growth that is eroding demand for natural resources from the world’s biggest shipper of coal and iron ore.”

Meanwhile, “The global economic downturn has pushed Australia’s economy into its first recession since 1991, Reserve Bank of Australia Governor Glen Stevens said.” According to the minutes from the RBA’s last meeting, “Conditions in the labor market continued to soften” and “Further falls in employment and rises in unemployment were expected.” These observations should be viewed in the context of a 5.7% unemployment rate.

The near-term prognosis for the Australian economy remains quite poor, regardless of whether a recovery materializes in 2010, as forecast by economists. Accordingly, analysts expect the RBA to lower its benchmark interest rate further, probably to 2.25% or 2.5%; there is a “bias toward further modest rate cuts, although we continue to think that the RBA may well pause for a few months to assess the impact of the current round of fiscal stimulus,” offered one forecaster.

Given the lull in market activity, some commentators have turned to technical analysis. “Westpac Currency strategist Robert Rennie said their own risk measurement models are clearly flagging a bumpy period ahead for high yielding currencies. ‘Our proprietary models are…clearly telling us to watch risk sentiment and data much more closely than we have over the past six weeks.’ ” In short, traders should not become complacent as result of the Aussie’s recent rally, and should continue to monitor economic data for signs of progress and/or hiccups on the road to recovery.

Swiss Franc in Spotlight

The Swiss Franc is in the same boat as the US Dollar and Japanese Yen, benefiting from an increase in risk aversion and an unwinding of carry trade positions. In other words, the currency rising on the back of the sound monetary policy of the National Bank of Switzerland, with its low rate of inflation and proportionately low interest rate. Despite the fact that the Swiss economy is poised to contract in 2009, its economy is in better shape than its rivals, and its current account balance is still in surplus. As a result, the consensus among analysts is that investors will continue to flock to the Franc, as Switzerland is sill perceived as a relatively low-risk place to invest. Especially compared to the Euro, which has risen against the Dollar of late, the Swiss Franc remains undervalued. Bloomberg News reports:

Investors are drawn to the franc in times of international tension and economic upheaval because of the country’s history of neutrality and political stability.

NZD, AUD Down in 2009?

While the Australian Dollar and New Zealand Kiwi technically started 2009 in the black, most analysts believe that both currencies will continue their record declines that began in 2008. All economic indicators continue to point downward, due to the adverse conditions created by the worldwide recession. The economies of Australia and New Zealand are extremely dependent on exports of raw materials and dairy products, respectively. Unfortunately, due to a contraction in demand and a decline in speculation, the prices for both types of commodities appears unlikely to erase even a fraction of the losses suffered last year. The death blow into the heart of both currencies will likely be delivered by their respective Central Banks, which are expected to make additional interest rate cuts. This will further erode the rate differential with the US/Japan, that previously signaled the currencies as attractive investments. Bloomberg News reports:

The average forecast is for the currency [AUD] to reach a low of 62 cents in the first quarter before recovering to 66 cents by the end of 2009. New Zealand’s dollar…will bottom at 52 U.S. cents in the second quarter and recover to 55 cents by the end of the year…

Credit Crisis Pummels Australian Dollar

The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels. Now that investors are chasing stability/capital preservation instead of yield, however, the currency has seriously fallen out of favor. The Australian reports:

Equity markets would continue to drive currency markets, while being influenced by the ongoing financial crisis. "These are unprecedented times in volatility for the Australian dollar and currencies," said [one analyst].

SA Rand Latest Victim of Credit Crisis

Over the last two months, the South African Rand has plummeted, losing nearly 20% of its value against the US Dollar en route to a five-year low. It seems the currency has become the latest victim of the credit crisis and the resulting widespread risk aversion. The sudden exodus away from the carry trade, for example, has affected the Rand disproportionately, as many foreign investors had come to South Africa over the last few years to take advantage of the country’s 12% interest rate. Now, the country is facing a horrible crisis, and is worrying about its ability to finance its current account deficit, which already exceeds 7% of GDP. Accordingly, analysts predict the Rand will continue to drop. Bloomberg News reports:

"The portfolio flows we have seen over the past couple of years are going to dry up and we will not be able to fund the deficit with the portfolio flows." The rand may slide to 9.20 rand by the end of the year…

Parity Party for the AUD

Is the "parity party" on or off? That is the question on the minds of currency traders following the Australian Dollar. Last week, analysts indicated that the party had been postponed, if not cancelled entirely. This week, there are signs that perhaps some of the bearishness surrounding the AUD is overblown. To be sure, the Australian economy is slowing, and the Central Bank will almost certainly lower interest rates. At the same time, some analysts believe that commodity prices have fallen too far, and will recover in time, as the long-term fundamentals that have underlied their rise still remain in place. Besides, the currency’s losing streak is already the worst since 1980, which suggests investors have gone too far. The most likely scenario is a bumpy 2008 for the currency, followed by a strong 2009. News.com.au reports:

[One analyst] said a recovery in global commodity prices could give the currency a much-needed bounce over the next few months. Citigroup has also forecast that the global markets have turned "too bearish" on commodity prices.

Bank of Australia Lowers Rates

It would seem as if the world is conspiring against the Australian Dollar. In the last couple months, the currency has plummeted nearly 20% from the 25-year high it had reached against the US Dollar. A combination of global economic weakness, falling commodity prices, and a trend towards risk aversion have turned the tables in favor of currencies perceived as more stable in times of crisis. To add insult to injury, the Central Bank of Australia decided to cut its benchmark lending rate, narrowing the interest rate differential that had been partially responsible for the Australian Dollar’s multi-year appreciation. Bloomberg News reports:

"In the near term, the question will be do we hold here or go down a bit more on interest rates?” said [Central bank Governor Glenn] Stevens.

Australia, New Zealand to Lower Rates

I won’t lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it’s easy to forget that there are unique circumstances that weigh separately on them.

Over the next 12 months, both countries’ Central Banks are expected to significantly lower their benchmark interest rates as a result of slowing economic growth. However, as New Zealand does not have a large stock of natural resources to depend on in times of economic turmoil, it is projected to lower rates quite sharply, compared to Australia. Accordingly, the Australian Dollar may represent a buying opportunity against the Kiwi in the near-term. Bloomberg News reports:

New Zealand’s dollar is likely to fall 8.7 percent to NZ$1.33 versus Australia’s by year-end as the nation’s economic slowdown accelerates, boosting prospects the RBNZ will lower borrowing costs…according to RBC Capital Markets.

Reserve Bank of Australia Could be the First to Hike Rates

Based on the chart below, which plots the Australian Dollar against the New Zealand Dollar over the last two years, one might be tempted to conclude that the two currencies are identical for all intents and purposes. Rather than suffer the inconvenience of separately analyzing the Australian Dollar, why not just read yesterday’s post on the New Zealand Dollar, and leave it at that?


But this chart belies the fact that while the two currencies, have risen and fallen (in near lockstep) in sync with the ebb and flow of risk aversion, this could soon change. While the near-term prospects for the New Zealand economy are dubious, sentiment towards the Australian economy is more consistently optimistic. “Central bank Governor Glenn Stevens said the nation’s economic downturn may not be ‘one of the more serious’ of the post-World War II era.” In addition, “Stevens said the nation’s economy may rebound faster than the central bank had predicted six months ago on improving confidence among consumers and businesses alike.” The latest projections are for a fall in .5% contraction in GDP in 2009 followed by a 1% rise in 2010.

Meanwhile, government spending is surging: “The Australian government forecast its largest budget deficit on record of A$57.6 billion for fiscal year 2009-10, or 4.9% of GDP.” Combined with the steady recovery in commodity prices and the resumption of residential construction, this could soon trickle down through the Australian economy in the form of inflation. It’s no wonder, then, that the Reserve Bank of Australia (RBA) could begin tightening interest rates as early as December, in order to mitigate against the possibility of inflation in 2011 and 2012.
In fact, Governor Glen Stevens has been raising eyebrows with his unequivocal comments about raising rates. “I’ve never seen written down … I’ve never heard in discussion in the institution, some rule of thumb that says we wait until unemployment’s peaked before we lift the cash rate…I think it depends what else is happening, and also depends how low you went. We eased very aggressively,” he said recently. As a result, traders are betting that rates will be 1.13% higher one year from now than they are today.

This development should be of especial interest to forex traders. Australian interest rates are already the highest in the industrialized world. When you consider “the market’s expectations that the RBA is likely to be the G-10 central bank which is likely to hike first,” it goes a long way towards explaining the 18% rise in the Aussie that has taken place in 2009 alone. Compare a hypothetical 4% RBA benchmark rate to the .1% in Japan and ~0% in the US, and carry traders will start to salivate.

Canadian Dollar Slated to Outperform Other Commodity Currencies

In the same vein as Monday’s and Tuesday’s posts (covering the New Zealand Dollar and Australian Dollar, respectively), I’d like to use today’s post to look at another commodity currency – the Canadian Dollar. The Loonie, it turns out, has also benefited from the a recovery in risk appetite and concomitant boom in commodity prices; it has appreciated by 7% against the USD in the last month alone, en route to a ten-month high. “All in all, with almost everything going its way these days (besides the crummy weather and the impact on tourism), a return trip to parity – last visited nearly one year ago – doesn’t seem far fetched,” chimes one optimistic analyst.

Like Australia and New Zealand, Canada’s economic fate is tied closely to commodity prices. Simply, as oil and other natural resources have inched closer to last year’s record highs, the Loonie has rebounded proportionately. “Raw materials account for more than 50 percent of Canada’s export revenue. Crude is the nation’s largest export.” Of course, this relationship works both ways. Any indication that the global economic recovery is stalling, and commodities prices would likely tumble, bringing commodity currencies down likewise.

Unlike the Australian Dollar and New Zealand Dollar, the Loonie has never really held much appeal as a carry trade currency. Even at their peak, Canadian interest rates were mediocre, from the standpoint of yield. The current rate is a measly .25%, compared to 2.5% in New Zealand and 3% in Australia. Moreover, while Australia may begin tightening as soon as the fall, “The Bank of Canada committed to keep its key policy rate at the lowest possible level until the spring of 2010,” after voting to hold rates at yesterday’s rate setting meeting. This interest differential could explain why the Aussie has outpaced the Loonie of late.

Another key difference – and potential explanation for the currencies’ recent divergence – is that Australia is considered part of the Asian economic zone, while Canada’s economic fortunes are closely aligned with those of its main trading partner, the US. China, alone, is helping to lift Australia out of recession. The US, meanwhile, is still struggling to find its feet. Hence, it is projected that Canadian GDP will contract by 2.3% in 2009, while Australian GDP may fall by a modest .5%. “When things look bad, you are more likely to sell Canada than the Australian dollar because its economy is moderated by Asian growth,” explains one analyst.

Going forward, this regional differentiation could actually work to the advantage of Canada, which is forecast to grow by an impressive 3% in 2010, compared to 1% growth in Australia. Accordingly, one analyst advises that “Investors should sell Australia’s dollar against Canada’s as a ‘relative commodity play’ because an attempt by China to reign in bank lending on concern it may be creating asset-price bubbles could slow Asian growth…’The Canadian dollar should outperform because it is much more closely linked to a recovery in the U.S.’ “

Australian Dollar Rises, Remains Closely Correlated with Stocks

The performance of the Australian Dollar over the last six months has been nothing short of incredible: “Since the end of February, the Australian dollar has risen 29% against the U.S. currency,” and a still-impressive 18% if you backtrack to January, when the Aussie was still in free-fall.

As has been the trend in forex markets of late, the currency’s rise cannot be attributed to an improvement in fundamentals. The economic picture remains nuanced (that is putting a positive spin on it), and definitive proof of recovery has yet to emerge. “We really are trawling pretty deep to try and get any snippet of information that might have some backhanded relevance as far as Australia goes,” said one analyst.


As a result, fundamental analysts have been forced to wait for a “more precise picture about the timing [of] any Reserve Bank of Australia interest rate hike.” On this front, investors are ratcheting down their expectations of a rate hike anytime soon, as “The RBA has signaled that there’s a danger of raising rates too soon.” Futures prices reflect the expectation that rates will rise by only 37 basis points from current levels before 2010, and by 161 basis points 12 months from now.

With such economic uncertainty, investors have turned their attention elsewhere. “Nomura Chief economist Stephen Roberts said in the absence of any clues about the fundamental drivers of the currency, nearly all the cues in foreign exchange markets are being taken from equities.” Some analysts have posited a close relationship with the US stock market: “The correlation between the Aussie dollar and U.S. equity market in particular has been very strong over the past few weeks, with our analysis showing a correlation as high as 95 percent.”

For other analysts, the relationship is with the Chinese stock market. This correlation makes more sense logically, since the Australian economic recovery is largely contingent on continued growth in China and the concomitant purchases of Australian commodities. “Currency markets will be watching the Shanghai share market, which has been a pretty big influence on the Aussie recently,” summarized one analyst. A reporter for the WSJ tried to spell it out even more clearly in an article entitled, “Australian Dollar Up Late, Closely Tied To Chinese Stocks.”

Unfortunately, the correlation with (Chinese) stocks runs both ways. When the Chinese stock market tanks – often for inexplicable reasons – as it has for the last three weeks, the Australian Dollar follows suit. Another analyst is more blunt: “The story for the Australian dollar and other risk- and growth-oriented currencies is similar to the share markets. They’ve had a great run and are probably due a bit of a pullback.”

Central Banks Prop Up Dollar

By all accounts, the decline of the US Dollar has been measured, and without incident. This, despite the fact that most investors reckon the Dollar is doomed, both from a long-term and a short-term perspective. What, then, is preventing an all-out collapse?

Personally, I think the best answer is that Central Banks (and their sponsoring governments) don’t want the Dollar to collapse. In other words, a schism is forming between private investors and public government, whereby investors (on a net basis) are rooting against the Dollar, while Central Banks are rooting for it. That’s not to say that there is a global conspiracy involving Central Banks, designed to prop up the Dollar. Rather, it is that Central Banks are simply trying to protect their short-term financial interests, and long-term economic interests. By this, I mean simply that foreign Central Banks have everything to gain from a strong Dollar, and seemingly everything to lose from its collapse.

From an economic standpoint, foreign Central Banks also benefit from a strong Dollar, especially those whose economies are powered by exports. “A stronger local currency relative to the dollar attracts foreign investment and tempers domestic price pressures by keeping import prices in check, but also cuts into the competitiveness of the country’s export sector.” Given that inflation is currently a moot issue whereas economic growth remains tenuous, Central Banks have made it clear that they currently favor weak currencies. “If (their currencies have) too much strength and the U.S. recovery falters, it’s bad for emerging market growth,” and could even lead to a so-called “double-dip recession.”

In order to alleviate this possibility, many Central Banks have intervened directly in forex markets and depressed their currencies through the purchase of Dollars. During only one trading session earlier this month, “Asian central banks said to be intervening in currency markets overnight by buying dollars included South Korea, Hong Kong, Taiwan, Thailand, the Philippines and possibly, Indonesia, according to analysts.”

Meanwhile, Central Banks in industrialized countries are using increasingly strong rhetoric to try to talk down their currencies. The Banks of Canada and England have achieved modest success in the last few weeks in convincing investors that overvalued currencies would be met with decisive action. The Royal Bank of Switzerland has intervened several times, while the European Central Bank has expressed concerns about “volatility” (code for the rapid appreciation in the Euro) in forex markets. It’s still not clear where the Bank of Japan stands. The newly appointed Finance Minister has already flip-flopped several times, settling finally on a course of action that would prevent the Yen from rising too high and threatening the nascent recovery.

Consider also foreign Central Banks’ collective holdings of US Treasury securities, which increased by nearly $800 Billion over the last year, a large portion of which was accounted for by the Banks of China and Japan. According to the most recent Federal Reserve data, they are collectively adding to their stockpile at a pace of $10 Billion per week. As the WSJ explains, “The inflows highlight the challenges facing nations with large dollar holdings, particularly developing countries. A weaker dollar is, in theory, bad for their investments as it eats into returns when translated back into local currencies.”

In other words, continued foreign Central Bank investment in US Treasury securities is perhaps rooted less in investment strategy, then in the simple desire to prevent their current holdings from depreciating. At the same time, those banks that intervene directly in forex markets often have little choice other than to hold their forex reserves in US Treasuries.



You can see from this that the idea of an alternative reserve currency would actually run counter to the interests of many of these Central Banks. With the exception of a few (i.e. Iran, and to a lesser extent, China) that would like to see the Dollar fail for political reasons, the vast majority of banks have a vested interest in the Dollar remaining where it is. Otherwise, they would witness the value of their Dollar-denominated assets collapse, as well as a collapse in exports to the US.


It looks like, then, there will be a showdown at some point between the Central Banks and investors. If you accept the notion of efficient markets, then it should be obvious who will win in the long-term. On the other hand, you can’t underestimate the determination of some of these banks.

How will Foreign Investment Tax Affect the Real?

On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.



It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (”Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.