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Sunday, March 30, 2008

The end of the carry trade

I see no sign that the carry trade will end soon, in fact I think its as strong as ever. The critical issues are:
1. Japan's growth prospects depend on local deregulation and/or immigration
2. Japan's interest rates are linked to its mercantilist trade policies - that will not die until the USA makes it an issue. It might well be a concerted effort by EU/USA that makes the difference given the recent strength of the Euro.

Based on the fact that there is no sign of change on these fronts, we can expect:
1. Japan to continue its mercantilist policy - Japanese interest rates to remain low
2. Japan to retain its subdued levels of economic growth

As long as Japan has interest rates at 0.5%-2%, we will continue to see carry trades. But the carry trade is not a single trade, rather a series of trades, in & out based on the performance of the respective currencies. It cannot be considered to be purely a AUD play, anymore than it canIf not in Australia then other countries. So buying JPY/AUD may only hurt if Australia does be considered a CAD$ or RSA play. Its all a matter of respective merit. You can be sure however that the AUD and NZD will feature highly because of their merits and high yields.

I see little possibility of the AUD being displaced by other currencies as a better 'carry'. There are not many candidates for the very reason that makes the AUD such a great trade. These are commodity exposure (RSA, Canada dont match), relatively free market, periodically big spenders (terms of trade implications), best China/India exposure (terms of trade implications), and commodity exposure (best worldwide).
I dont see Australia loosing this status because of China/India. I cant see Asia gaining it because they will be big savers for a long time, and they are prone to subsidise interest rates. I would suggest more likely you will see Japan end the carry trade. At some point Japan & China will be forced to drop the mercantilist trade policy they learned from Britain. I dare say it will take the USA to repudiate, or threaten to repudiate its debt before it does that. Really the USA doesn't even have to do that. The USA is holding tangible assets, Japan & China are holding paper that is becoming more worthless by the day. I think the USA wants a monetary crisis because its holding real assets. After that, you can expect a huge rally in the Yen, and alot of reform in Japan to deal with its lack of competitiveness. Its the kind of crisis Japan needs.

Actually probably the greatest rival to the AUD for the carry trade is likely to be the USA. The Fed is currently subsidising short term rates to delay the inevitable rise in interest rates in an election year. You can expect that the USA will lag on rate increases whereas Australia is having an early start because of the strength of its economy. The housing boom has ended in Australia, but alot of new investment is going into mineral export capacity, eg. nickel, coal, iron ore, natural gas, mostly being spent in WA. This investment in the short run will boost domestic demand, so the economic outlook remains strong, with investment offsetting a weak consumer sector being hurt by rising interest rates on home loans. I wonder the extent of variable home loan exposure in Australia. If there was high awareness of inflation then maybe Australian consumption might hold ok. At some point there will be a shift to the USD/JPY, but it will flow back to AUD/JPY when that mineral export capacity kicks back in. Remember the bulk commodities market remains tight. There is inflation, but this is no bust. There is no huge over-capacity, so any slowdown will be painful but it wont create a huge overghang of capacity for some time yet.
Andrew Sheldon

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