Role reversal: the Australian dollar and the carry trade

Ultra-low rates in Australia have turned a longstanding “carry trade” on its head, creating new opportunities in the currency markets.

Data on net immigration and wage growth, and lessons from Japan could provide guidance on where the Australian dollar – and the carry trade – will go from here. Whether this will continue depends on a decision from the Reserve Bank of Australia, the country’s monetary authority, about Yield Curve Control (YCC) on 6 July, according to new research from BNP Paribas Markets 360 strategists.

What is a carry trade?
Central banks around the world have responded to the unprecedented disruptions caused by the Covid-19 pandemic by cutting interest rates to record lows. As countries recover at differing speeds, their changing rates give rise to trading opportunities: currencies can be borrowed in countries with lower rates and invested in higher-yielding assets in the currencies of countries with higher interest rates – a strategy known as the carry trade.

“Currency traders have traditionally regarded the Australian dollar (AUD) as a cyclical currency with a value driven by the relative strength of commodities prices,” explained Parisha Saimbi, G10 FX Strategist at BNP Paribas. “As the country’s economy is driven by its exports of minerals and agricultural produce, the AUD strengthens when demand for these products is strong.”

To keep inflation down, the Reserve Bank of Australia (RBA) has generally kept lending rates higher than in other countries, which attracts foreign capital and strengthens the AUD.

This dynamic has provided currency traders with compelling hedging opportunities. Japanese financial institutions in particular have long employed a carry trade based on their country’s low interest rate environment, using JPY to purchase higher-yielding Australian assets.

Since the onset of the global pandemic, this situation has changed. Now traders are borrowing AUD at low rates to invest in higher-yielding currencies elsewhere.

Reiko Tokukatsu, G10 Rates Strategist at BNP Paribas

Accommodative policies

The RBA’s response to the Covid-19 crisis has driven this turnaround. Back in March 2020, the RBA reduced its cash rate target to 0.1 per cent – the lowest in history – to keep the AUD’s value down and support growth. It has committed to keeping rates low until 2024, and it has relied on three key measures to do so. The first, quantitative easing (QE), has become well-known globally since the 2008 global financial crisis. Under QE, the RBA buys government bonds in the open market. Its first QE programme, announced in November 2020, committed A$100 billion to bond purchases. In February 2021, as the pandemic continued, the RBA extended the QE programme by another A$100 billion.[1]

The second measure is a Term Funding Facility (TFF): a three-year scheme to lower funding costs throughout the banking system, keeping the cost of credit low so that lenders are incentivised to support businesses and households.

The final measure is a programme of Yield Curve Control (YCC), also known as interest rate caps, which focuses on government bonds with maturities of up to three years. The RBA has pledged to buy enough bonds in this sector of the yield curve to keep the rate from rising above a target yield of 0.25%.

A forward roll

These ultra-low rates have reversed the AUD’s role in the carry trade – but the trade’s future profitability depends on whether the RBA maintains the monetary policies that have kept the AUD relatively weak.

“With YCC and the central banks’ bond purchases coming up for review at the RBA meeting on 6 July, we are looking to data on net immigration and wage growth, and taking lessons from Japan for some guidance on what will happen next,” said Tokukatsu. 

At the meeting, the RBA may extend YCC by rolling it forward to include the November 2024 bond. The RBA is monitoring a number of data points to inform their decision. These include net immigration, which has been falling more steeply than in other countries; wage growth, which the RBA believes must reach 3% if its inflation target is to be met; and house prices, which have not risen as rapidly in Australia as they have elsewhere.  “We think that data about Australia’s population growth hold the key to whether YCC is rolled forward to include the November 2024 bond – and to the future of the carry trade. If the RBA feels strongly about a potentially structural issue such as population growth, as well as the need for wage growth to rise to 3%, rolling the YCC to the November 2024 bond is supported,” said Tokukatsu. “Hence, we think that the next labour market release can be important.”

Japanese lessons

The YCC decision will have implications for Japanese investors, who have been active in the AUD carry trade. In March 2020, the AUD fell to a low of $0.5738 against the USD as the coronavirus crisis took hold. That attracted investors to borrow the low interest rate AUD and convert the borrowed amount into assets in a higher-yielding currency, like US or Canadian dollars. The experience of Japan, which has been grappling with long-term monetary policy easing for longer than other developed economies, suggests that the decision about a loan support programme like the TFF can be separated from YCC. In 2016, the Bank of Japan pledged to peg its 10-year bond yield at nearly 0% as a way of encouraging inflation to rise above its long-term lows and stimulate economic growth.

Financial institutions involved in the AUD carry trade will hope that the RBA decides to take this into account. If Australia’s central bank does extend YCC, we expect this could put pressure on the AUD to weaken.

Parisha Saimbi, G10 FX Strategist, BNP Paribas

Financial institutions involved in the AUD carry trade will hope that the RBA decides to take this into account on 6 July. “If Australia’s central bank does extend YCC, we expect this could put pressure on the AUD to weaken,” confirmed Saimbi.


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