Bloomberg: Australian dollar has become the most favored currency for carry trade strategy

Source: Bloomberg

Author: Matthew Burgess

Article: Original article

Publication date: Sunday, November 13, 2022

Carry traders' search for a funding currency revealed an unexpected winner — the Australian dollar.

Strategies aimed at profiting from the difference in interest rates between higher-yielding and lower-yielding currencies generate the largest returns when they are funded by the Australian dollar, rather than the US dollar, euro or British pound, and about the same return as the official currency of Japan — the yen. Improved indicators resulted from the dovish tilt by Australian policymakers since early October, which is different from the hawkish policy in the US and Europe.

While the US dollar has fallen after the latest US inflation figures were released, most financial managers are still reluctant to put an end to the dollar rally until the Fed pauses its monetary policy tightening. However, it is unlikely before the middle of next year, given the signals of the money market. This means that volatility will remain elevated, and the Australian dollar may be funding currency for carry traders well until 2023.

Carry trades in emerging markets, funded by the Australian dollar, have yielded an average of 3.1% since the Reserve Bank of Australia elected to slow the breakneck pace of interest rate rises on October 4. That is almost twice the returns from dollar transactions seen before the last inflation report was released, despite the fact that there were brief bursts of risk-on sentiment that kept the US currency from rising.  

The gap between the RBA's policy and the Fed's policy has made it possible to reverse the negative correlation between emerging-market currencies and the Australian dollar. This reduces the level of risk of a carry trade funded by the Australian currency.

According to Alvin Tan, the head of Asian currency strategy at Royal Bank of Canada in Singapore, short selling US dollar is expensive and the cost is likely to rise. On the contrary, the RBA’s recent changes in policy should cause the difference in interest rates between the Australian dollar and other currencies to offset against the Australian currency's favor.

The Australian dollar is not popular when funding a carry trade. It is usually favored for arbitrage traders, especially in yen trades. The Japanese currency and other lower-yielding currencies such as the euro are the most preferred options to the dollar in real world. However, the current conditions of the global foreign-exchange and bond markets result in other norms.

The yen's weakness may have already reached a peak as traders fret about further interventions by officials to prop up the Japanese currency. The euro is set to strengthen amid the hawkish remarks by the ECB officials. Traders are currently avoiding the British pound as well. 

However, other options, including the Australian dollar, may not be so favored if the dollar continues to fall. Four consecutive months of fighting inflation in the US have reduced pressure on the Fed and revived the rally in risky assets. 

Therefore, the Australian dollar cannot replace the US dollar, but acts as a diversification alternative for funding carry-trade transactions. RBC's Tan suggests using Australian dollar-funded carry trades to hedge against volatility in a traditional portfolio. 

Forecast: AUDUSD fall