Euromoney: Aussie rate hikes revive the carry trade

Chris Wright

Has ever a non-US rate rise been so closely watched? On October 6, the Reserve Bank of Australia raised interest rates by 25 basis points to 3.25%, thus becoming the first developed nation to start tightening monetary policy since the global financial crisis. In some measure, it signals a formal end to the crisis.

It didn’t go down universally well. Ben Potter, research analyst at IG Markets in Melbourne, calls it “both extraordinary and unnecessary”. In his view the RBA had plenty of time and scope to delay rate hikes until after Christmas, and since there were no imbalances in the economy there was no obvious need to put rates up. “We cannot fathom today’s decision, especially considering the global rhetoric from the recent G20 meeting that it’s too early to begin withdrawing stimulus and normalising rates,” he said on the day of the announcement. Reserve Bank governor Glenn Stevens argued that since Australia’s economic growth in 2010 looks likely to be close to trend, there was no argument to keep rates at such low levels and it was better to start to normalize policy.

Whatever the pros and cons of the decision, it may trigger a broader trend in capital flows: the revival of the yen carry trade and its equivalents elsewhere in the world, notably the US. Before the crisis, Australia was a classic beneficiary of these trades – while one could borrow at negligible rates in places like Japan, risk-free bank account deposits in Australia could give you 7%, which, while not the highest in the world, was certainly the highest among relatively low-risk countries. That changed as speculators pulled back funds from late 2007 onwards, and as Australia cut rates, reducing the attraction.

If Australia now starts raising rates progressively, then the distinction between what capital will get you almost risk-free in Australia versus the rest of the world will become all the more acute. It’s not inconceivable that interest rates could be back up to 4% before the US Federal Reserve moves its own rates above 0.25% – a sixteenfold better return for an Aussie dollar deposit over an American one. One can already see international capital getting the scent of this idea in the fact that the Australian dollar has strengthened considerably since the hike.

“The carry trade is getting turned back on again,” says Shane Oliver, chief economist at AMP Capital Investors. “I think it has a fair way to go as confidence continues to build in the global recovery but rates remain low in key countries like the US and Japan. It will be fed further by the Reserve Bank continuing to raise rates here whereas the US will be on the sidelines until the middle of next year and Japan’s hike might be more than 18 months away.”

CommSec chief economist Craig James thinks overseas investors will be attracted by Australia’s interest rates and economic performance, but also because of its exposure to China’s industrialisation, for which he says “Australia is in the box seat for the next decade.” As it is, the country has fared the crisis remarkably well, continuing a run of 17 years of economy expansion, with only one quarter of contraction (a 0.6% drop in 4Q08) meaning that it ducked a technical recession.

The rate hike may not have much of an impact on the debt capital markets, though: although it “represents an attractive environment for investors” and “issuers shouldn’t have any shortage of buyers,” in the short term equity will probably be cheaper and more attractive, James says.