Will The Carry Trade Continue To Favor Australia?

In late August, we looked at the aussie dollar and thought it was due for a sell off, and it did for a modest couple hundred points. Then it turned around and rallied from 1.0165 to a high of 1.0624. It has since backed off from the high, but remains above the 1.04 handle. Where do we go now?

Part of our analysis in late August was based upon a longer term fundamental view that the global economy was slowing, as was the demand for iron ore, Australia's biggest earner of aussie dollars. Further, the A$ was, and is richly priced, making it difficult to export other Australian products.

Also, the late August COT report showed the specs were long 98.1K futures contracts -- a big commitment. Usually going into the expiration of a futures contract, there is liquidation of positions. This meant the big long position might weigh on the market. There has been some reduction in the OI, but it is still big, with the specs were still holding onto 75.5K contracts, according to the last report.

The turnaround in the A$ during September was caused when the Central Banks in China, Europe, and the U.S. all decided it was time for some stimulants. China intends to do this with infrastructure projects. Draghi, at the ECB, will have the European version of quantitative easing -- a version that gives those in Frankfurt and Berlin supervision rights over the wayward debtor countries. Next, Fed Chairman Bernanke, not to be upstaged, decided to expand the Fed balance sheet and print $40B every month until the U.S. unemployment rate comes down. The philanthropic Bernanke continues, offering nearly free money until sometime in 2015 -- a year after he is supposedly out of office.

Finally today, Japan joined the money printers group, announcing it will expand the BOJ's balance sheet with the purchases of $100B plus of sovereign debt.

The central bank announcements in Japan and the U.S. set up quite nicely for participants in the carry trade. Money in the U.S. and Japan is practically free. The Australian bank rate is 3.5%, although the yield curve there is slightly inverted. (Rates are lower for longer term loans) The one year bill rate in Australia is 2.89%, and the two year is 2.81%, compared to .17% and .25% in the U.S. for the same maturities. In Japan, rates are even cheaper, with the one year yield only .09%, and two year bills .10%.

Australia has been a favored investment destination. Its bonds are rated AAA, the GDP grew at 4.3% last year, and Westpac this past August estimated the growth rate will be a very creditable 3.5% for 2012. With stable growth in Australia and attractive rates, the A$ has also been gaining favor as a reserve currency. Switzerland, Germany, and China are among those who have been buying the aussie dollar.

The strength of the aussie is a mixed blessing, making imports cheaper and exports more expensive. As the mining boom slows, Australia will be better served by a weaker currency, but with the interest rate spread between Japan and the U.S., carry trade players will continue to move funds to Australia.

Currently, the equity and currency markets are confronted with a plethora of concerns, which will provide volatility. Australia is acutely concerned with the Chinese economy, but the possibility of a global economic contraction is another consideration. How severely would the A$ be hurt in a "risk off" situation?

There are other international concerns. What is going to happen in the spat between Japan and China over ownership of a few small islands in the China Sea? Will Germany continue to dictate austerity programs that destroy growth in Europe? Why is an armada of vessels congregating at the Strait of Hormuz? Will Iran's nuclear development be attacked prior to its completion of its bombs? Is the pending U.S. election a concern for markets?

On periods of strength in the A$, around the 1.06 handle, we wish to sell the AUDUSD (NYSEARCA:FXA). Eventually, we think the bears will prevail, but not without a battle. A strong aussie will hurt their economy. To combat this, the Reserve Bank of Australia should cut the bank rate. The next scheduled meeting of the RBA is October 2. There should be some nice volatility ahead of this report.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.