A new international carry trade has emerged to replace the traditional yen/US dollar carry, which has huge implications for the Australian economy. The new carry trade is US dollar/Australian dollar.
A carry trade is where the investor borrows in a low-yielding currency and lends in a high-yielding currency. It requires a stable foreign exchange environment because the play is typically unhedged and you can get wiped out if either of the two currencies move sharply.
But if things stay calm a fund manager can make easy consistent returns and be standing in front of a bucket of balls at the driving range by 3pm. For those with a little more appetite for risk, the returns can be super-charged with more leverage.
After the Japanese economy collapsed in 1990 and the Bank of Japan left interest rates at or near zero for two decades, the yen carry trade – borrowing in yen and lending in US dollars, usually via high yielding securities – gradually became hugely popular.
It’s estimated that by 2007, more than $US1 trillion had been put on yen/dollar carries, and much of the money found its way into subprime US mortgage securities, hugely inflating the US credit bubble.
Even though official Japanese interest rates are slightly lower than those in the US, it’s now cheaper to borrow in US dollars than yen because of the collapse in Libor to below 50 basis points. The London interbank rate recently fell below the similar benchmark in Japan.
In turn, that’s because the Fed has been the most aggressive central bank and the global financial system has been flooded with dollars, not yen. What’s more, US interest rates look likely to be anchored around zero for at least a year, although hopefully the US economic malaise won’t last as long as Japan’s.
And what’s the new favoured destination for funds looking for a safe carried return on cheap US dollar borrowings? Australia.
As the ‘Heard on the Street’ column in the Wall Street Journal commented this morning, Australia has “a stable currency, resurgent economy and elevated interest rates”.
It’s a carry trade utopia, and it’s the reason the Australian dollar has started to surge in the past few days.
The US/Australia exchange remained steady at around 65 cents between October last year and March this year, after the flight from risky assets following the collapse of Lehman cut it by 20 cents in a week or two.
It then rose to 80 cents in early June, catching the global stockmarket rally and the general return to favour of risk investments, and stayed around that level for a couple of months.
Now it’s above 87 cents and there’s a new factor at play: the emergence of a US dollar carry trade, with Australia as a key destination.
This has massive implications for the Australian currency and our credit markets.
Already there is a developing movement here towards fixed interest securities, driven by retail fund allocations away from equities. Last week, for example, $3.5 billion was subscribed to Commonwealth bank’s PERLS 5 hybrid issue, even though the bank only wanted a third of that, and ended up taking $1.5 billion.
The combination of growing retail demand and international investors looking for safe high-yielding securities to park their US dollar carry trade money in will give a huge boost to Australia’s fixed interest credit markets.
Banks are likely to be big beneficiaries of this, and probably already are. They have raised huge sums this year from international markets using the government guarantee, and a lot of that is undoubtedly funded with cheap US dollars.
Of course, in the United States the long-running yen carry trade eventually turned into too much of a good thing – a credit and banking bubble that busted with tragic results – but it took a long time and required a hopelessly inadequate regulation system.
Australian authorities need to ensure the same thing does not happen here.
In the meantime, importers and exporters should prepare for an even higher exchange rate and investors should hang onto their bank shares.
This article first appeared on Business Spectator.
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