Australian Dollar can Advance Even Further as the 'Carry Trade' is Back in Favour

The Aussie Dollar's strong start to the new year continues with the currency being the past week’s outperformer in G10.

The Australian Dollar is the year’s best performing major currency having advanced by 6.10% against the US Dollar, it has meanwhile advanced 5.04% against the British Pound.

Above: The Australian Dollar is the best performing G10 currency against the Pound in 2017.

The economy continues to tick forward with the Reserve Bank of Australia content to sit on the sidelines and keep interest rates steady.

The important Chinese economy is growing at a faster than expected rate which is in turn keeping Australian exports well bid.

Yet, business-as-usual is hardly a justification for the currency's strong outperformance, and can the outperformance continue?

Understanding why the Australian currency is doing so well can help us determine whether or not further gains can be expected.

Why AUD is Doing Well, and Why it Could Continue to Do So

It’s all about interest rates and interest rate expectations right now.

Global investors are pushing gargantuan sums of money to countries whose money markets offer good yield, and the currencies of these countries benefit as a result.

Take the South African Rand which is another star performer of 2017 - the basic rate offered at the South African Reserve Bank is 7.0%.

Investors are able to borrow at dirt-cheap levels in the Eurozone, UK and Japan that have interest rates ranging from negative to 0.25%. The return for just parking borrowed money in South Africa makes for an attractive proposition.

And with a basic interest rate of 1.5%, Australia is looking pretty good too.

This strategy is known as the ‘carry trade’ and is one of the most important foreign exchange drivers out there.

“The current environment has been favourable for carry currencies;” says Tejas Sathian at UBS in London.

Sathian says US Federal Reserve Chair Yellen’s testimony to the US senate this week should help maintain this environment as there is no sense of urgency to hike rates rapidly in a way that would destabilise the trade.

“Carry trade investors typically look for higher yielding currencies with low volatility – effectively trying to avoid the currencies where big daily swings can wipe out several weeks/months of yield gains,” says Christopher Turner, Global Head of Strategy at ING Wholesale Banking in London.

And analysts are confident that the current environment will remain supportive of the two antipodean currencies for some time yet.

“Which G10 currencies are least likely to gain against the USD from current levels?” asks Tejas Sathian. “The standouts to me are AUD and NZD, given the extent of the moves seen so far this year.”

This leaves those with GBP into AUD conversions in a difficult position as it suggests the exchange rate is likely to continue falling.

Indeed, our latest analysis suggests the pair is en route back to 2016 lows.

The 1.60 point has been tested on occassion but Sterling bears have been unsuccessful in prompting a noted break.
We would be confident that the selling pressure would run out at this point.

Until then though, we have full confidence in the Australian Dollar's ability to strengthen against its British counterpart.

Australian Dollar: What Lies Ahead

Concering the near-term outlook, markets will be watching the release of RBA minutes on February 21 and hearing from RBA Governor Lowe on February 22 and 24.

"Recent communication from the RBA has had a fairly positive tone. Comments around housing, the labour market, wages and inflation will be important," says a note from ANZ Research on the matter.

Data-wise, the Wage Price Index release for the fourth quarter 2016 is released on February 22 and markets will be looking for signs that wage growth has stabilised.

Wage growth is important in that it tends to raise inflation which in turn puts the pressure on the RBA to raise rates which in turn only increases Australia's 'carry' appeal.

A range of indicators, including ANZ job ads, are pointing to better employment growth in the months ahead.

"The likely lengthy lag between any acceleration in employment growth and wages means there is unlikely to be any sense of urgency from the RBA even if employment outcomes do improve, in our view. We think there is still a reasonable amount of slack in the labour market," says David Plank at ANZ Research.

Looking into 2017 ANZ do think there is likely to be a pickup in wage costs.

The ANZ Wage Gauge has been rising since March 2016, in line with this, unit labour costs have stabilised. They seem set to lift in 2017.

This should provide further support to the Australian Dollar.