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Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

2020-04-25 19:00:00
Christopher Vecchio, CFA, Senior Strategist
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Central Bank Watch Overview:

  • G10 currencies’ central banks are taken extraordinary measures to stem the economic fallout from the coronavirus pandemic. Aside from cutting rates all the way to zero, some central banks are embarking on quantitative easing (QE) for the first time.
  • The commodity currencies – AUD, CAD, and NZD – typically benefit from their higher yield profile relative to other currencies (the carry trade). This relative appeal has been wiped out.
  • Retail trader positioningsuggests that more gains may be ahead for USD/CAD rates, losses for AUD/USD rates, and sideways price action for NZD/USD rates.
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Central Banks Lean into Most Aggressive Easing, Ever

The coronavirus pandemic poses a threat to the global economy unseen in history. G10 currencies’ central banks have taken notice, and have responded in kind – some faster and more decisive than others. While the Federal Reserve has leaned into aggressive, extraordinary policy steps, others like the European Central Bank have been slower to deliver the bazooka stimulus required.

Away from the Fed and the ECB, other central banks have been relying on more traditional monetary tools in order to keep credit flowing: rapid, heavy handed interest rate cuts. Now, every single major central bank associated with each of the eight major currencies has lowered its main interest rate to all-time lows.

For the commodity currencies, this is bad news: historically speaking, the Australian, Canadian, and New Zealand Dollars have been the major ‘carry trade’ currencies, offering a higher yield relative to the lower yielding safe havens like the Japanese Yen, Swiss Franc, and US Dollar. To this end, there is no more yield advantage for the trio of commodity currencies.

Bank of Canada Rate Cuts Complete – Look for Extraordinary Policy

The Bank of Canada’s place in the response to the coronavirus pandemic appears to be settled. After immediately cutting the main interest rate to an all-time low of 0.25%, the BOC has been sitting on its hands. At the April BOC policy meeting, rates were kept on hold while new financial market stability mechanisms were announced in order to help keep credit flowing to businesses and households.

Bank of Canada Interest Rate Expectations (April 24, 2020) (Table 1)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

According to Canada overnight index swaps, rates markets think that the BOC is done operating via the traditional interest rate mechanism and will instead focus on extraordinary policy efforts, similar to the Federal Reserve to the south. Through the end of 2020, there is only a 1% chance of a rate hike, and the maximum probability for a rate cut arrives in September at 5%.

IG Client Sentiment Index: USD/CAD Rate Forecast (April 24, 2020) (Chart 1)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

USD/CAD: Retail trader data shows 47.14% of traders are net-long with the ratio of traders short to long at 1.12 to 1. The number of traders net-long is 17.34% lower than yesterday and 9.30% lower from last week, while the number of traders net-short is 1.23% lower than yesterday and 12.12% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests USD/CAD prices may continue to rise.

Traders are further net-short than yesterday and last week, and the combination of current sentiment and recent changes gives us a stronger USD/CAD-bullish contrarian trading bias.

Reserve Bank of Australia Could Act Again

The Reserve Bank of Australia has cut its main overnight interest rate five times over the past year, dropping the main rate to an all-time low of 0.25% in March in response to the coronavirus pandemic. But that’s not all: the RBA has announced that it will embark on its own quantitative easing (QE) program, a step that was not taken during The Great Recession. This pursuit will achieve the goal of keeping the three-year bond yield at 0.25% for the next three years.

RESERVE BANK OF AUSTRALIA INTEREST RATE EXPECTATIONS (APRIL 24, 2020) (TABLE 2)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

According to Australia overnight index swaps, there is a 58% chance of a 25-bps rate cut at the May RBA meeting. But given the commentary from RBA Governor Lowe suggests that the central bank is not prepared to move rates into negative territory, making any further rate cuts unlikely; the pricing may be a quirk due to the shape of the Australian bond yield curve.

To this end, the RBA has said that it will target the three-year bond yield at 0.25% - the same rate as the overnight cash rate – which is a reasonable assumption that the RBA will keeping its overnight cash rate at 0.25% or lower for at least the next three years.

IG Client Sentiment Index: AUD/USD Rate Forecast (APRIL 24, 2020) (Chart 2)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

AUD/USD: Retail trader data shows 43.63% of traders are net-long with the ratio of traders short to long at 1.29 to 1. The number of traders net-long is 13.63% higher than yesterday and 9.92% higher from last week, while the number of traders net-short is 4.55% lower than yesterday and 0.66% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests AUD/USD prices may continue to rise.

Yet traders are less net-short than yesterday and compared with last week. Recent changes in sentiment warn that the current AUD/USD price trend may soon reverse lower despite the fact traders remain net-short.

Reserve Bank of New Zealand to Keep Rates at Record Lows

The Reserve Bank of New Zealand has cut its main interest rate to an all-time low of 0.25%, but that hasn’t stopped calls for more action. A few weeks ago, RBNZ Governor Orr mentioned that he has not ruled out moving interest rates into negative territory in order to help stem the economic collapse onset by the coronavirus pandemic.

RESERVE BANK OF NEW ZEALAND INTEREST RATE EXPECTATIONS (APRIL 24, 2020) (Table 3)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

As such, interest rate markets are open to the idea that the RBNZ may be lowering rates again over the course of 2020. Through the last meeting of the year, the November RBNZ meeting, there is a 37% chance of a 25-bps rate cut. Contributing to the heightened expectations for more dovish policy action have been additional comments by RBNZ Governor Orr that extraordinary policy measures such as quantitative easing (QE) have not been ruled out.

IG Client Sentiment Index: NZD/USD Rate Forecast (APRIL 24, 2020) (Chart 3)

Central Bank Watch: Carry Trade Yield Appeal Wiped Out for AUD, CAD & NZD

NZD/USD: Retail trader data shows 42.37% of traders are net-long with the ratio of traders short to long at 1.36 to 1. The number of traders net-long is 4.42% higher than yesterday and 5.83% higher from last week, while the number of traders net-short is 10.58% lower than yesterday and 5.94% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests NZD/USD prices may continue to rise.

Positioning is less net-short than yesterday but more net-short from last week. The combination of current sentiment and recent changes gives us a further mixed NZD/USD trading bias.

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Recommended by Christopher Vecchio, CFA
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

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