The Carry Trade

Hey team,

By now you should be pretty aware the investing community is convinced interest rates in the United States are going up. In fact, if you polled a bunch of bankers, they’d probably tell you they’re hung over from last night and the stripper dollars in their pockets are yours. They only tip with hundreds. They’d also tell you they’re expecting the Federal Reserve (which is the United States’ central bank) to increase rates at least three times this year.

Just like in Australia, interest rates are increased in 0.25% (or 25 basis point) increments, so three rate hikes mean that interest rates in the US are expected to be at least 2.25% by year end up from the 1.5% they are today.

All in all it’s baaaaaaad news for the Aussie Dollar. Or at least that is the fear from many of the “leading” financial analysts.

Wait, what? 
Before I go on…..

This is not a prediction or an estimate or a forecast or any other nonsense. 

There are two things which really drive the strength of a currency. I won’t bother you with the first, as I know you’re busy, so let’s just talk about the second. Deal? Cool. You know how different banks offer you different interest rates? And how if you were less lazy you’d actively move your savings to which ever bank is offering you the best rate at the time? Well really large investors do the same thing. Except, they’re not lazy, so they actually do it.

But they don’t just move money inter-bank chasing the highest interest rates. They do it inter-country as well.

The Carry Trade
The “Carry Trade” is a multi-trillion dollar trade (yes trillion) where investors borrow money in countries where interest rates are low and then invest it in countries where interest rates are high. Sounds pretty simply right? Borrow in countries where the borrowing costs are low and then invest the proceeds in the countries where the savings rates are high. Pocket the difference. Nice little profit there.

The thing is, the difference in interest rates between countries doesn’t haven’t have to be particularly large for this to make sense because of the size of the trades these large investors are making. Right now, between Australia and the US, there is no difference. The RBA has set the official interest rate at 1.5% and the Federal Reserve has adopted the same rate.

However, going forward investors THINK the US will be increasing rates, whereas they EXPECT Australia to leave theirs unchanged throughout the year. As a result, there is an expectation that investors will soon be jumping over themselves to get in on this trade to borrow AUD to invest in USD.

The key point here is this. If you are borrowing in Australia so you can invest in the United States, you are going to have to SELL AUD and BUY USD. And remember, when there are more sellers than buyer’s prices go down and when there are more buyers than sellers, prices go up. So more selling in AUD should push its price down and more buying in USD should push its price up.

As this difference in interest rates between Australia and the US starts to materialise, more and more investors are going to start selling Aussie dollars to buy US dollars. The result of which is expected to significantly push down the value of the AUD.

And the faster the US increases interest rates relative to Australia, the more the AUD could (not will) fall.

Quickly in other news

  • Trump did this
  • The market is probably going to do this
  • I’ll write why on Monday

For now, that’s 5 minutes. Hope it helped. 

Categories: General Finance, Macro Economics

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