Carry Trade Unwinding?

[Graemsay]

The FT has a piece about Carry Trades as a leading indicator on their Alphaville Blog.

A Carry Trade involves borrowing money in one currency where there's a low yield, and investing it in another with a higher return. For example, a trader might use the US, UK or Japan, where interest rates are below 1%, and reinvest borrowed capital in somewhere like Australia.

As well as the arbitrage opportunity between national interest rates, there's also the chance to profit from currency movements.

The post quotes Simon Derrick as saying.

Probably the most iconic of currency pairs when considering the “carry trade” over the past decade and a half has been AUD/JPY. Since June of 1995 the pair has staged two major rallies (June 1995/May 1997 and September 2001/July 2007), each followed by around 12 months of ultimately inconsequential trading and a subsequent collapse that ended up taking the pair right back to where the uptrend had started. Tellingly, although the turn from the absolute peaks in May 1997 and July 2007 were (of course) marked by spikes in measured volatility, the subsequent 12 months or so of inconsequential trading (prior to the major collapse) were, in each case, characterised by a clear decline in historical volatility. In both cases in the weeks immediately before the collapse, 21 day historical volatility (measured on a OHLC basis) had declined to around 12% before subsequently spiking very sharply higher.

Why does this matter today? The most obvious reason remains the growing risks to broad sentiment in global markets (whether from the unpredictable path of events in the MENA region or the risk of a third stage to the Eurozone crisis). Added to this, of course, remains the rather more cautious tone adopted of late by senior members of the RBA (notably, Governor Glenn Stevens on February 11th: “It is probably reasonable that there will be no hike in interest rates for some time’) along with concerns expressed about the strength of the AUD by, amongst others, Prime Minister Julia Gillard. There is, however, a third reason, namely the price action itself. In particular it is noticeable that since the price peaked out in May of last year it has become locked in an increasingly moribund pattern (as has our flow data for the AUD). In line with this, after an initial spike in 21 day historical volatility last May, the past ten months has seen a steady decline leaving it currently standing at around 11.23% (making it just about the quietest period since the summer of 2007). Given our observations about market conditions in the summers of 1998 and 2008 this seems worthy of note.

If the carry trade is reversing then that could mean less foreign capital flowing into Australian banks, and it could also presage a fall in the price of the Australian dollar on currency markets.

So a negative for property prices would be less lending, but a positive would be that houses would be cheaper to foreign investors.