The Volatile Australian Dollar

Alan Kohler wrote the following on 9th May 2011:

Don’t be misled by last week’s commodities crunch, the Australian dollar is heading higher – much higher. That’s partly because of the return of the carry trade.

On the same day, John Taylor (CEO and founder of FX Concepts) told the Australian Financial Review:

The Australian dollar is really high now – I thought it was going higher but now I’m not so sure. Things are going to turn… basically, the currency is going to come off the flame and things are going to start slowing down.

Kohler in his usual emphatic writing style is absolutely certain of an “explosive” Australian dollar. Of course he hasn’t done any research himself, he’s latched onto some thoughts of economist Tim Toohey on the $A/Yen carry trade.

Kohler is a journalist who has been wrong on many occasions previously but you wouldn’t know it from the way he writes. After all, he has grey hair, appears on TV, wears a suit and sounds plausible – enough for most people to believe him.

John Taylor on the other hand is a very experienced operator in the currency markets and has made many correct calls in the past. John Taylor doesn’t share the views of Kohler and Toohey.
Those of us who actually operate in markets, as opposed to writing about markets or living in economic ivory towers, will know instinctively why Taylor holds the view he does.

On any measure the $A is over-valued. The $A/Yen carry trade has been a factor, but the point that Kohler and Toohey miss is that playing the carry trade when the $A is at these levels (against most other major currencies) is a fool’s game. Why? Because:

1. The $A is trading at levels 40-50% above its long range valuation;
2. The $A is one of the most volatile currencies in the world - wild swings in value are normal (and dangerous for would be speculators);
3. The Reserve Bank of Australia is holding off on interest rate rises for as long as it possibly can (it really does worry about all those terribly over-leveraged “home owners” – but they won’t admit it);
4. There’s no point getting a few extra percentage points in interest if you end up ultimately losing a good part of your capital.

Of course, as is the case in any mature bull market, a large part of the price increase (just before the fall) is due to hedge funds and the like taking wild speculations with other people’s money, creating artificial demand, while trying to make some quick returns in an upwards trending market (i.e. collecting nickels in front of bulldozers).

All though much less of a factor, there are also all those individuals who are relatively new to markets and through CFDs are able to leverage their minimal capital 100-200 times and speculate in currencies. There will be some that have made easy money in recent times speculating on the $A/$US pair, but once again, they are picking up nickels in front of bulldozers. Just wait and see.

In any bull market you will always find those people who say “this time is different” as a means for justifying insane prices. However, things are never truly different – they just temporarily appear to be different before all of a sudden (and from seemingly nowhere), conditions return to their previous state.