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Has Australia’s Rate Cut Put the Carry Trade at Risk?

The Australian dollar carry trade, popular among investors to cash in on the interest rate differential between countries, is under threat following the Reserve Bank of Australia’s (RBA) interest rate cut, say forex strategists, who expect further policy easing by the central bank this year.

Australian Notes - Mixed
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Australian Notes - Mixed

“The Australian dollar carry trade has already come into risk with the interest rate differential lessening between the Australian dollar and the U.S. dollar, which makes up 40-50 percent of all our in-house carry trades,” Michael Judge, Corporate Forex Dealer at OzForex, told CNBC on Wednesday.

“The interest rate markets are now factoring in at least 25-50 basis points (of rate cuts) by year-end, which would see us move down to record interest rate lows last (seen) in April 2009,” Judge added. He expects 50 basis points of rate cuts before the end of the year.

Since the global financial crisis, the Australian dollar has been regarded as one of the most attractive carry trades by investors, as the RBA was the first G-20 central bank to lift rates in October 2009.

However, the RBA’s move to cut interest rates by a greater-than-expected 50 basis points to 3.75 percent on Tuesday - its biggest cut since the last financial crisis – has narrowed the interest rate spread between the Australian dollar and the main funding currencies of the carry trade, the U.S. dollar and Japanese yen.

Sean Callow, Senior Currency Strategist at Westpac Bank, who also forecasts further rate cuts of 50 basis points this year, agrees that the shrinkage of the yield differential makes the Australian dollar carry trade much less appealing.

“The two-year yield spread between the Australian dollar and U.S. dollar is at its lowest since June 2009,” Callow said. “The shrinkage of the yield differential doesn’t make the trade compelling in my view, particularly if you have to hold the position for an entire 12 months. A yield of 3.75 percent is not attractive right now,” he added.

In addition to the interest rate risk hanging over the carry trade, Callow says the risk of increased volatility in the currency market stemming from Europe’s sovereign debt crisis, also makes it less attractive.

“If you conduct a carry trade you are leaving yourself a wide window for volatility to return in the next 12 months,” he said. Carry trades are seen as more attractive in an environment of low market volatility.

Instead of getting locked into longer-term positions of over 12 months to obtain yields of around 3.75 percent, Callow says spot or short-term transactions offer more attractive returns.

“We prefer trades based on expected short term movements in currency pairs, whether spot or options. For example, in late March, we went short the Australian dollar-Japanese Yen at 86 via options and spot, which is now trading at 83.1,” Callow said.

Renewed Demand for Aussie Carry Trade

Jesper Bargmann, Head of G11 Spot FX, Asia Pacific at RBS Global Banking & Markets, however, disagrees that the Australian dollar carry trade is at risk, pointing to a pick-up in demand from Japanese retail investors.

“Over the past few months, Japanese retail investors were venturing towards more illiquid currencies like Brazilian real, but now they are looking back at Australian dollar as a more traditional carry trade,” Bargmann.

“The Australian dollar is being viewed as more of a safety currency too. It is more stable than other emerging markets that offer a higher yield,” he added.

Unlike Callow of Westpac Bank, who sees the Australian dollar falling back to parity by June, Bargmann forecasts the currency will stay above parity the whole year.

“The Aussie will move back up to US$1.06-1.08 level in the next six months driven by sovereign demand, particularly from Asian countries and Russia,” he said.

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