The surprise in the currencies over the last month is the strength in the yen, despite the new 1% inflation target by the Bank of Japan. This inflation target should be a reason for a weaker yen, but instead has strengthened over the last month. The yen is only a few percent from it's all time highs.
What is happening, and how does it relate to the Australian Dollar?
Capital flows holding up the yen relate to the unwinding of the popular AUDJPY carry trade. This unwinding is about to switch into high gear, due to recent events - and this will cause problems for the AUDUSD.
The core component of the carry trade for the AUD has been the high overnight rates of the Reserve Bank of Australia, their central bank. Australia's overnight rates have been between 3.75% and 5% higher than rates in the U.S. and Japan since the crisis.
Australia weathered the crisis relatively well:
- Their housing market remained strong even during the worst parts of the crisis
- Chinese demand for commodities remained strong during the crisis
But inflation threats during that time were high for Australia - which compelled the RBA to keep overnight rates high.
These three factors set up perfect conditions for a profitable carry trade.
Then, the AUD was smashed during the worst days of the crisis due to the "risk off" trade, but their economy was actually fine. After the worst of the 2008-2009 crisis passed, the AUD was dramatically undervalued, Australia had a booming economy, and had high interest rates.
The AUDUSD and AUDJPY rallied massively off their 2009 lows and today are near record highs.
But today, the Australian Economy has nearly an exact opposite situation:
- Australian housing market is imploding: down 10% in a few months
- Chinese demand for Commodities appears to be slowing
On top of this, the Australian economy has much lower than expected inflation.
This is all bad news. In response the RBA lowered their economic forecast, and most recently shocked the market with a .5% rate cut.
Did I mention the AUDUSD is near all time highs, and is one of the most overvalued currencies in the world?
We know how central banks react when faced with housing market problems: They cut rates aggressively. The RBA cutting rates by .5% is probably just the first in a string of aggressive rate cuts. Low inflation + a bursting housing bubble = near zero overnight rates within 9 months. Ouch.
I suspect much of the recent strength of the Japanese yen can be traced to some carry traders unwinding their positions, where they sell their AUD positions and buy back their short JPY positions.
But there is probably a limit to how much stronger the JPY will become in the short run. We do know the Bank of Japan is firmly committed to its 1% inflation target, and the BoJ has intervened directly in the currency markets in the past.
Additionally, I think on the value of the yen and will not allow the Yen to get much stronger than its current levels.
Any further unwinding of the Australian Dollar carry trade is likely to happen in the AUDUSD rather than in the AUDJPY.