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Reverse Carry Trade, Part II

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As we discussed yesterday, if a nation's central bank lowers its interest rates, the usual expectation is that it will weaken its currency. Part of the reason why: it will set up a carry trade, in which profiteers will borrow money at its low rates, then exchange that currency for another currency, that issued by a higher-interest rate country, so these profiteers (I use the term without animus -- it simply means "those seeking a profit") can lend out for a higher rate than the one at which they are borrowing, pocketing the difference. This activity, given supply/demand principles predictably weakens the currency the profiteers are leaving and strengthens that into which they're moving.

This brings us back to the mystery with which we began. Australia and New Zealand have both recently lowered interest rates. In each case, though, that has corresponded to a strengthening of the currency. Back in late May, you would have needed 1.39 Aussie dollars to buy a US dollar. By August 10 that was down to around 1.30.

What is going on? Perhaps part of the answer is a "reverse carry trade." Could profiteers actually have decided to work it the other way around? To exchange the higher interest rate currencies for the lower? And if so ... why?

Cignarella suggests that there is a reverse carry at work. The reason? Capital appreciation. One wouldn't borrow at a high rate to lend at a lower one, but one might borrow at a high rate to buy assets within a country, or a currency zone, with a lower rate.  Thus, one would accept interest rate losses and in return reap more-than-compensatory capital gains on those assets.

Is this happening? I don't know. Cignarella doesn't actually make a very emphatic case for it. He simply suggests that those who are "puzzled" by the counter-intuitive moves in Forex markets "should consider" the potential for a reverse carry.

Okay, consider it considered. I'll keep an eye out for further discussions of and perhaps evidence that this is underway.

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