One of the prominent mainstream aussie bloggers Duncan Riley has a post in which he’s trying to work out what is up with the aussie dollar.
One of the key factors in the recent decline of the aussie dollar is what is known as the carry trade.
The key thing with carry trades is relative interest rates between the countries, if I can borrow money for 1% in one country and earn 7% interest in another country then it’s a damn easy way to make 6% interest, leverage that position and we have some very attractive returns, this is not to mention that we might also make some outright returns if the currency we have bought continues to go up as more people do what we are doing. When some people get nervous and start closing their positions down, then it’s a stampede with everyone getting out as quick as they can. To do this, they need to sell their high yielding currency and buy some of the lower yielding currency in order to pay back what was borrowed, the result? The high yielder falls, the low yielder rises, when there is a stampede this happens very quickly.
The most popular currency to be the low yielder is the Japanese Yen which can be borrowed for next to nothing. Then it’s a matter of taking your pick of the higher yielding currencies, with Australian interest rates recently at 7.25% it was a fairly popular choice as the high yielder. This was great, until it looked like Australian interest rates had peaked. Since then there has been a rush for the doors which has seen the currency tumble down at an alarming rate.
I’ve included below a weekly chart of a popular carry trade, the GBPJPY (My charts didn’t have enough weekly data on the AUDJPY to give a good picture), you’ll notice that it goes up and up and up relatively slowly for weeks on end, then it falls like crazy in a single week.
For those that aren’t traders though are reading this, when the chart is going up (green) that means the GBP (British Pound) is increasing in value, the JPY (Japanese Yen) is falling in value… the opposite is true when the chart is falling and the candles are red.