In our latest post Fed, ECB and BoE: exit strategy far from certain we anticipated that an exit strategy from the expansionary monetary policy that major central banks have pursued over the course of the past two years, although not imminent with respect to the Fed, the ECB and the Bank of England, would be implemented soon by many western economies. We also suggested that the Norwegian Central Bank would likely be the best candidate to raise interest rates, following the Bank of Israel’s rate hike last September. But, considering the whole of the G20 countries, last week the Reserve Bank of Australia (RBA) unexpectedly increased rates from 3% to 3.25% - a hasty move for some economists. The RBA decided that it was time to start removing the expansionary monetary policy it had been implementing since September 2008, with rates down from 7.25% to 3% in just a few months. With GDP declining only in Q4 2008, the Australian economy has not entered the recession of the past two years and the recovery of Asian economies, its major trading partners, has led the RBA to estimate that economic growth could be pretty close to trend growth in 2010. Further rate increases may therefore be implemented over the coming months: according to Morgan Stanley, rates will likely be raised to 3.5% by the end of 2009 and to 4.5% by mid-2010.
The RBA surprise move impacted on the currency market, where the Australian Dollar gained substantial ground against both the Euro and the U.S. Dollar, thanks to the sharp increase in carry trades (i.e. borrowing in a low-yield currency and investing the funds in a higher-yielding currency to gain from the difference). Contrary to economic theory, carry trades have historically yielded high returns for extended time periods but have entailed serious losses during financial turmoil. In a study published in July 2009 "The Revenge of purchasing power parity on carry trades during crises", Briere and Drut, two economists of the Université Libre de Bruxelles, have shown by using the cross currency exchange rates of the eight major developed economies (the U.S. dollar, Euro, Yen, English Pound, Swiss Franc, Australian Dollar, New Zealand Dollar and Canadian Dollar) that carry trades yield higher returns than those offered by a strategy built on the Purchasing Power Parity (PPP), but only due to the performance posted during normal market phases.
In fact, during a financial crisis, when the Vix (Volatility Index on the S&P100 options) rises by one standard deviation above the long-term moving average, carry trades lose ground while a PPP-based strategy earns positive returns. A study by the Bank for International Settlements (BIS) published in the Quarterly Review of December 2007 ("Risk in carry trades: a look at target currencies in Asia and the Pacific") illustrated the profitability of carry trade operations with reference to some Asian countries (Indonesia, India and the Philippines).
As the Australian Dollar trend showed last week, identifying the next central bank to tighten, widening the interest rate differential with other currencies, is likely to ensure a good performance to investors. As for the eight currencies analysed by Briere and Drut, the outlook for the Norwegian Krone appears to be rosy. Not only is the currency key rate already higher than that of the U.S. Dollar, Swiss Franc and Japanese Yen (the three main financing currencies), it should also benefit from the interest rate hikes that will be likely implemented in the aftermath of the October 23 meeting. Another candidate to become a buying currency in carry trades is the New Zealand Dollar, as the interest rate level (2.5%) should remain higher than in other countries, although economists at Morgan Stanley have recently estimated that a rate increase by the New Zealand Central Bank should not materialise before Q3 2010. By contrast, the Central Bank of Canada rate hike, which Morgan Stanley expects in Q1 2010, will likely have a modest impact on exchange rates. With rates at 0.25%, in fact, only expectations of a severe monetary policy tightening could drive up the Canadian dollar.
However, as we said before, carry trades will remain profitable as long as the ongoing positive phase of the market continues. A deterioration in financial market conditions, which would be evidenced by a sharp increase in the Vix above the 30 threshold, would make it necessary to focus on the currencies with a greater undervaluation against the PPP, in line with the findings of Briere and Drut. The table below illustrates the over/under valuation of the G10 currencies against the U.S. Dollar on the basis of OECD data. The U.S. Dollar appears to be undervalued and the Swiss Franc, the Norwegian Krone and the Australian Dollar are among the most overvalued G10 currencies against the US Dollar. According to a Deutsche Bank report released in 2007 ("Currencies: Value Investing" by Bilal Hafeez), which indicated that a strategy based on the sale of overvalued G10 currencies on the basis of the PPP and on the purchase of the most undervalued currencies translated into positive performances between 1980 and 2006, the Swiss Franc, Norwegian Krone and Australian Dollar would be the three currencies to short, while the U.S. and Canadian Dollar and the Pound would be the currencies to buy.