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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

Monday, March 24, 2008

Outlook for the AUD - a brave man's forecast

Reading some commentary on the Australian dollar I seem to be at odds with most of them. The SMH asserts “The Australian dollar may fall 7% in the next two months as commodity prices weaken and global equities decline”. The AUD reached a one-month low of USD90.97 last Thursday, down from its high of USD94.98 on 29 Feb 2008 – last reached on 29 March 1984. The argument for a weaker AUD is “The commodity story from here will be mixed to negative and risk appetite is being unwound”. On that note I am in wonder – where is the risk:
  1. Commodity prices are resilient because of the weak USD. Where is the compelling evidence for a stronger USD? I can see some weakness for commodity prices but not a great deal.
  2. Commodity prices are mostly (coal, iron ore, bauxite) sold forward on 1 year annual negotiations and prices are higher than last year along with volumes
  3. Agricultural commodities are set to be a contributor since the drought-breaking rains last year, so might we expect added zest to the AUD on those export flows
  4. Australian consumer confidence has slumped so we can expect weaker imports
  5. The spread with Japan is even better at 6.75% since the BOJ is offering 0.5%. You might think this is a problem because Australia is a commodity currency, but consider markets are driven by yields and capital growth. I don’t see much prospect for capital growth in the current market, so I am confident the AUD will get supported on the basis of yields. Why else would you buy bonds?
  6. Australia’s public debt as a % of GDP is the best in the developed world at just 15% of GDP. The only positive legacy of the Liberal Party. That gives the current government a lot of capacity to soften any downturn with public spending. One might make the argument that Australia has huge private debt, but its mostly real estate stock and it could be readily absorbed by higher migrant inflows. I would not be surprised to see the Australian Labor government lift immigration intakes, though it will need to pay off the Greens with more national parks and windmills.
  7. Australia is one of the governments that has raises interest rates, so preserving the attraction of the AUD for the Yen carry trade. The cash rate for the AUD is 7.25% after the RBA raised rates this month – thats a 5% spread over the Fed’s 2.25% on March 18.

I have just one qualification – money supply growth in Australia based on statistics I downloaded on the weekend is very high. In fact its at historic highs. The positive implication is likely to be that the Australian government will reign in that money supply by raising rates, at a time when the Fed could possibly lower them more. The USA is going into recession, and more importantly it faces an election.

“Risk aversion remains the dominant factor holding back the Aussie against the US dollar” according to Commonwealth Bank chief currency strategist Richard Grace. I don’t disagree with this, but that is the basis of buying opportunities. The reality is that no where is there growth prospects, so true no one is looking for growth from Australia, however I think the agricultural sector will surprise the market. I also think yield rules in these conditions. Australia is also a significant natural gas exporter and commodity prices in US terms still look good if you agree that the USD is going to its all-time low of 85Yen. I would suggest that Australian commodity export capacity is alot more tangible than the USD banking system. The gold sector is going to be another great performer for Australia in coming years. The other factor supporting the AUD is likely to be efforts by Asian governments to boost their domestic economies in the wake of a weakening US economy. Its worth considering the capacity of Asian governments to do this:

  1. Australia – public debt 15% of GDP – but high external debt
  2. China – public debt 21% of GDP
  3. Korea – Its public debt is 23.8% of GDP
  4. USA – Its public debt is 36% of GDP - but high external debt
  5. UK – Its public debt is 43% of GDP
  6. Canada – Its public debt is 55% of GDP
  7. India - Its public debt is 58% of GDP
  8. Germany - Its public debt is 65% of GDP
  9. France - Its public debt is 66% of GDP
  10. Taiwan – 121% of GDP
  11. Japan – the Japanese public debt is 182% of GDP

If anyone has the capacity to lift spending its probably the USA, but I don’t expect it at a time of rising global inflation. I think the Democrats will raise taxation.

Lastly I want to reiterate - I dont see depreciation - but there will be alot of pain for holders of debt that is not fixed. You should have fixed your property loan rates, at least for the next 5 years.

Andrew Sheldon

Saturday, March 22, 2008

The USD-JPY soon to test Y100

The USD-JPY has recently found some support at 96.5Yen, though I still believe the USD is going weaker. I was actually surprised by how easily the 100 yen level was broken. Maybe it was just a reaction to the Bear Stearns failure, but I think the market is going to need more convincing that other financial institutions are not going to fail.
There might also be some market trepidation with the US presidency up for grabs. Looking at the chart above its apparent that the US dollar has been stronger over the last 5 days. I think its fortunes will be far worse next week. It was always going to retest that previous Y100 level it broke so easily. So having reached Y100, I think it will be fall back, eventually reaching the Y85 level. If I am wrong, we will know early next week.
Andrew Sheldon

Wednesday, March 19, 2008

Trade the AUD from Y90 to Y100

The following is a discussion I had on Japan Forum. Got a debate going on the outlook for the AUD against the Yen.
[QUOTE=tanmedia]If NZ and Australia have a debt crisis, there will be pressure to cut interest rates. The Reserve Banks of both countries are between a rock and a hard place at the moment.
Rising energy costs yet some of the highest debt in the developed world.[/QUOTE]
No question there will be a debt crisis but you need to consider 2 things: (I) Australia, and particularly NZ have run much more disciplined monetary policies than the US, so rates never sank to the level of USA, and Australia was far more prosperous. There were 'no doc' loans in Aust, but not to the same level of abuse. (II) The drought appears to have ended, so thats another $6bil of export revenues for next year at a time of rising prices.

[QUOTE=tanmedia] "The Aussie is hostage to competing forces rigth now. On one hand, the endless rise of world commodities prices and the great fall of the US Dollar are good reasons to back the Australian currency. Indeed, Australian exporters can take full advantage of rising gold, metals and energy prices." [/QUOTE]

Well most of those commodity price rises are due to falling USD of late so mixed impact. Precious metals are rising in real terms, base metals are falling. Bulk commodities like coal and iron ore are doing very well. But AUD is rising also because of agric export outlook and higher interest rates whilst US cutting its rates. So I agree with you there.

[QUOTE=tanmedia] "On the other hand however, there is a new event on the FX markets which is bearish for the Aussie: the liquidation of carry trades. Those long-term positions were based on the different interest rates on government bonds in different countries (a basic carry trade being to buy the high yield currency and sell the low yield one). [/QUOTE]

Eh, I thought we just agreed the outlook for AUD was good. I see it breaking $1 parity no question. But maybe you are talking in terms of USD.

[QUOTE=tanmedia]"The dominant carry trade of the last few years was a strong bearish force for the Japanese Yen. It was cheap for global spculators to borrow the yen because of ultra-low interest rates in Japan for years. Since last November roughly, investors become more and more risk averse, fearing a global slowdown and the unknowns of the credit crisis. [/QUOTE]

I think the crux of this argument is whether relative yields are important or absolute yields, and I would suggest relative yields, plus monetary policy. Aust is showing a tighter policy than Japan, so all things being equal, I think we are looking at Y90 being support for the $A. I think the carry trade is not one trade, but some with a long, others with a short term perspective. What forex traders also fail to see is the bent up demand for commodities, ie. The 100 ships waiting off newcastle port, the planned mines which cant get mining equipment. That is keeping metal prices along with strikes.

[QUOTE=tanmedia]"So what have they done? Yen carry traders are getting out of long-term winning positions to lock in profits. They're also making a big change in their asset allocation, which should favour commodities. That's why the Yen is currently in a massive up trend. It's rallied against all the high yield currencies, including the Aussie."[/QUOTE]

Looking at the AUD-JPY, I can see a great looking trade from Y90 to Y100. I think it would be imprudent to expect more. I think you'll find your market comments are old news and pundits are about to jump back into AUD, whilst some will just continue to hold it. The higher agricultural export volumes & prices will take time to come. Terms of trade should improve as well. Can you say the same about Japan with oil prices at $105-115/bbl. Australia producers about 30% of its oil, but add in NW Shelf gasm and it has a net fuel balance.
Andrew Sheldon

Sunday, March 16, 2008

George Bush believes in a strong USD

President George Bush said in the wake of the Bear Stearns bail-out, that “the US believes in a 'strong dollar”. Does that give you confidence? Surely that news is likely to push the USD to its all-time low of Y81.12 set on 19th April 1995. But we are a long way from that. I suspect the motive for the comment was to calm those governments holding large amounts of US treasuries, namely Japan, China and Saudi Arabia. Afterall why would a foreign government want to hold a basket of bonds in a depreciating currency on which real yields are also falling. So that’s the rhetoric to support buyers. Which raises the issue of whether the US government will have a problem financing its deficit. The US has had a succession of tax cuts under Bush, with the economy oftening it looks like there will be a series of tax increases in future. On the other side, who wants a weak currency at a time of weaker economic growth? Where is the value when most of your competitors are pegged to your currency? Only the Euro and commodity currencies like Australia, Canada and NZ offer competitive advantage, and they are not significant markets.

Currently the USD is trading at 98.05, well below its 2005 low 0f 101Yen. The doubts cast over the US economy, the high oil prices, the prospect of weaker global growth all seem to support a weaker USD, and more importantly the Fed is about to cut the Fed rate by another 1% to at least create the myth that there will not be a recession. The high oil price in USD terms is sure to undermine local spending too. It could not look much worse. The positive of course is that the USD can repay all its debts by merely flooding the world with USD. It is left holding a lot of very tangible assets, whilst Japan & China can monopoly money. But we are years away from that. Its all payback of course for the mercantilist policies in those countries. So sit back and watch the USD fall to 81.12 Yen. I actually though it would come later, but the Bear Stearns bail out will undermine confidence in financial institutions. I give the Fed credit – they are great at managing perceptions. If only they could manage money better.


Andrew Sheldon

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