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Why is the $A rising?

PSI |  28 March 2014  |  Economics

CurrencyThe Australian dollar is rising again, which underlines once again how difficult it is to predict the world's fifth traded currency. That is far out of proportion with Australia's size in the world economy. It is a bet in the casino that is the world capital markets. Most of the trade in the $A is with the $US, yet America is only our third largest trading partner.

There is a general downward trend of the $A against the $US:

 

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One reason for the $A's rise is that US bonds are flattening, which makes the interest rate on the Australian dollar attractive:

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US 10 year bond yields have fallen 1.3% to 2.66%:

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The spread (differential) with the Australian 10 year bond yield is widening:

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Why do interest rate differentials matter so much? It is a difference over a year -- interest rates are annual. Currencies can move more than that in a matter of hours. But in the capital market casino, it is signals that matter, not reality. The Economist explains it:

"What inspires investors to favour one currency over another? Perhaps the most consistent factor over the past 20 years has been the “carry trade”. This involves a trader borrowing in a country with low interest rates and investing the proceeds of the loan in a country with higher rates, and pocketing the difference.

In theory, it seems odd that the carry trade works. The most likely reason for one country to have higher nominal interest rates than another is because it has persistently higher inflation. Over time you would expect to see currency depreciation in the high-inflation nation because its exports will gradually become less competitive.

In the forward markets, which set prices for specified future dates, this rule is rigidly observed. When one country has a higher interest rate than another, its currency will trade at a discount to that of the other nation in the forward market. That discount will exactly offset the rate differential. So if euro-zone interest rates were two percentage points higher than those in America, the euro will trade at a 2% discount to the dollar in the 12-month forward market. If it did not do so, traders would be able to make a risk-free profit.

The forward market is a naive “forecast” of future currency movements. But an analysis by Record Currency Management of 33 years of data on five big currencies shows that the currency in the country with the higher interest rate outperforms the forward exchange rate slightly more often than not. This translates into a small monthly gain for investors."

It is why the future of the $A is so hard to predict. But for super investors, it is perhaps time to look offshore for investment possibilities.

 



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