Why the Australian dollar is heading higher: Kohler

Don’t be misled by last week’s commodities crunch, the Australian dollar is heading higher – much higher. That’s partly because of the return of the carry trade.

The message from the Reserve Bank last week was the rates are going up, probably in July, and notwithstanding the squalls that hit commodity markets last week, there’s nothing going on in the global economy that will prevent that.

The perception that the US economy is weaker than expected, which led to last week’s volatility, is simply wrong, a fact confirmed by Friday’s payroll data. Employment for April was much stronger than expected and past data was revised upwards as well.

Despite that, US and Japanese rates are still down for the count. The Fed will need a long period of employment growth before contemplating a rate increase, and even then it will be very cautious. And after this year’s disaster, Japanese interest rates are going nowhere.

As Goldman Sachs’ economist Tim Toohey highlighted last week, the yen-finance carry trade is now back at mid-2007 levels, with the counter trade time focusing on Australian dollars.

The carry trade is where you borrow in yen and invest the proceeds at higher yields in another currency. Before the crash it was typically in US dollars, but now it’s Australian dollars.

Economic theory suggests that currency movements should erode the interest rate difference over time, but in practice the opposite occurs because of what’s known as the “forward premium puzzle”: currencies that have a forward premium and a correspondingly low interest rate tend to go down, not up.

That means investors entering a carry trade make money two ways – from the yield differential and the exchange rate. The size of the yen carry trade is a mystery, but estimates range up to the trillions of dollars.

And it’s been reignited, according to Toohey, by the large interest rate differential between Australia and Japan, as well as the lower volatility in the AUD market and the large amount of yen liquidity after the earthquake (the bank of Japan injected 15 trillion yen into the system in March).

Adding to the demand for Australian dollars is a steady diversification out of US dollars by global central banks as well as the huge demand for dollars to finance the resource investment boom in this country. Toohey reckons these two factors are accounting $37 billion a year in demand for Australian dollars at the moment, and will do for some time.

The carry trade, meanwhile, caused the recent spurt to $US1.10. The commodity sell-off last week resulted in some profit taking in the Australian dollar, and there may be more of this in the short-term, but the longer-term impact of combining the carry trade with central bank and resource-investment buying could be explosive.

The yen carry trade can be a powerful force. It contributed to a 25% appreciation of the US dollar between 2005 and 2007, adding to the cash pouring into the US financial system from the Chinese central bank and contributing to the 2008 crash.

Now the Peoples’ Bank of China is buying Australian dollars and the yen carry trade is back as well – focusing on Aussie dollars.

This article first appeared on Business Spectator.