What seemed illogical actually makes perfect sense ..... at least it does in this strange world

Tuesday 16th August 2016

  

What seemed illogical actually makes perfect sense..... at least it does in this strange world

ref:- "What's Driving FX Isn't Just Yield  --  It's Reverse Carry", Bloomberg Markets

Remember back at the beginning of the year when the Bank of Japan surprised the markets by cutting rates into negative territory and reinvigorated its QE asset-purchasing programme? They were bold moves but only the latest in a series of strong measures designed to finally kick-start Japan's moribund economy and get some inflation going after decades of standing still. If they also had the effect of weakening the Yen, as it would have been perfectly reasonable to expect, well ..... that would be just a very welcome side-effect. A weaker currency of course provides a fillip to both growth (through cheaper exports) and inflation (through more expensive imports), but that was not part of the BoJ's STATED motivation.

It may be just as well that the Japanese authorities did not acknowledge any intent to weaken the Yen ...... as it's turned out, USD / JPY was trading around 120 back then and now as we write a surging Yen is hammering at the psychologically important 100 level. The Bank of Japan has steadfastly resisted the temptation to weaken the Yen through intervention in the Foreign Exchange markets up to this point, but a convincing break of 100 would put enormous pressure on them to act.

The whole thing is totally counter-intuitive ..... isn't the biggest fundamental driver behind FX moves the interest rate differential? With US rates expected to rise and Japanese rates very possibly moving further below zero, shouldn't that mean strength for USD / JPY?

Well if that was the whole story then sure, but the fact is that US rates are moving higher an awful lot slower than many expected (or wanted, for that matter). Even more of a factor, Japan's huge current account surplus and stable political environment means that the Yen has re-asserted itself as the most sought after "safe haven" currency. As panic gripped the markets earlier this year, any considerations of interest rate differentials were jettisoned as investors rushed into the secure refuge of the Jap Yen.

But looking at two much more recent and lower profile examples, the US Dollar versus both the Australian and the New Zealand Dollars, there's evidence that something else is at play in currency moves that also might seem illogical at first sight. The central banks of both those countries have cut rates recently, in common with others across the Pacific, and yet their currencies immediately strengthened against the greenback. This time there is no safe-haven status to explain buying of the Aussie and the Kiwi, which both jumped 2% or more, and there are further rate cuts expected from the Reserve Bank of New Zealand as early as November. 

In the sense that it's buying a currency with rates on the way down against selling one with rates on the up (supposedly), you could call this behaviour a "Reverse Carry Trade" (of a sort). The driver behind recent Aussie and Kiwi buying is not the now marginal level of interest rate differential still just about working in its favour but the much bigger potential for capital appreciation. The rising prices of assets in the newly purchased currency, fuelled by central bank rate cuts and bond purchase programmes (QE), offer the potential for the biggest profits, big enough even to absorb any losses through adverse interest rate carries if and when they occur. The most sought-after currencies will be those that offer a decent yield and security on assets AND potential capital gains..... which is why the Aussie and the Kiwi proved pretty attractive when a cursory look at their falling rate scenarios might have suggested otherwise .

Where central banks still have a little ammunition up their sleeve, their currencies may continue to benefit from this effect against lower yielding counterparts with no room left to manoeuvre. But beware ...... there are always plenty of other factors that can affect foreign exchange prices, and sometimes plays like this are only in vogue until something bigger comes along. Put it this way (and just as a hypothetical example, you understand ), if a Fed official was suddenly to give a hint that rates might rise earlier than the market had generally been expecting, these kinds of reverse carry trades would be the last thing on anyone's mind  --  except perhaps how to get out of them.