RBA governor’s tightrope walk | Forex volatility and the Carry Trade

Recently, the governor of the Reserve Bank of Australia, Glenn Stevens, remarked that those investors who had seen an opportunity in buying Australian government bonds would be wise to hedge their positions against a fall in the Australian dollar. The reason the Aussie is a risk to foreign bond buyers is that they must purchase it with their own currencies in order to participate in the bond market Down Under, and Stevens was engaging in that quintessential activity of central bankers: attempting to talk down a currency instead of taking direct action to achieve the same effect, such as lowering interest rates. In Australia this is known as “Jawboning”.

In Australia in particular, much as they would like a weaker currency in order to assist the economy, the fear of the RBA is that a further reduction in rates will serve to inflame an already very buoyant property market, particularly in housing.

Now Stevens is expected to take another opportunity, very early in the morning tomorrow in GMT terms, when he is scheduled to give a speech in Sydney (to the Anika Foundation). This origanisation was set up to deal with teen depression and would not immediately be thought of as a typical forum for economic discussion but the market, nevertheless, awaits Mr. Stevens’s words with considerable interest.

Forex volatility may assist

Volatility is a measure of the amount of movement in the price of an investment (or of the exchange rate in the case of a currency) in a given time, either up or down. It is measured by the beta factor in many economic equations, which is itself a proxy for risk.

A foreigner purchasing Australian bonds is one way of engaging in the Carry Trade, which is where investors will effectively borrow in a low interest jurisdiction and lend out in a high interest one. If volatility increases, which it is now showing signs of doing on the back in increased geopolitical tensions, it will tend to make the Carry Trade more risky, as the investment currency, in this case the Aussie dollar, could drop in value and decrease or eliminate the potential profits when the time came to change it back into the funding currency, as hinted at by Mr. Stevens.

Increased volatility could have the effect of assisting governor Stevens in his quest to reduce the value of the Aussie, as it will tend to discourage the purchase of the Australian unit for the purposes of the Carry Trade.