The currency/commodity conundrum

$A unloved as rates trump commodities (Link may requie subscription) The AFR reports:

Australia's shrinking interest rate premium and expectations of another US credit tightening kept the $A near 18-month lows overnight, despite surging prices for gold and base metals

Gold surged to three-week highs above $US567 an ounce, silver hit yet another 22-year high, while copper and zinc hit fresh record highs. Yet the $A sank to as low as US70.38, a level last seen in September, 2004, before moving back up to around US70.5 in early local trade.

Traders said the puzzling disconnect between the $A's weakness and commodity strength could be explained by the prospect of rising interest rates in the US, Europe and Japan alongside steady local rates.

"We doubt that the main driver of Australian dollar weakness is likely to disappear anytime soon - namely its fading allure as a yield play now that Japanese and Euro-zone interest rates will be heading higher," National Australia Bank currency strategist John Kyriakopoulos said.

Europe has raised rates twice since late last year and is expected to move again in the coming month, while Japan has signalled an end to its five-year old zero interest rate policy.

This has reduced the appeal of previously high-yielding currencies like the $A. As well, the local currency has suffered collateral damage at the hands of the New Zealand dollar after data last week showed the economy there skirting perilously close to recession

"The most prominent driver of the Australian dollar's slide is a clear unwinding of carry trades, where investors had borrowed in low-yielding currencies such as the euro, Swiss franc and Japanese yen to purchase high-yielding currencies like the Australian dollar," he said.

In a separate story, the AFR rounds out the picture:
Plenty of easy money despite the pinch (There's that subscription thing again.)

Investors wonder whether the monster sell-off in the high-yielding Australian and New Zealand dollars is a symptom of a coming convulsion in global markets. After all, the tightening in global liquidity conditions is worrying after an extraordinary era of cheap money funded an abundance of no-brainer risky investments that enriched many a trader these past years.

One of those gifts for speculators was the carry trade, a byproduct of super-low borrowing rates in places such as the United States and Europe. Japan, meanwhile, had a policy of stuffing extra liquidity into the banking system and borrowing rates at essentially zero. The carry trade - a strategy for borrowing at low short-term rates to buy higher-yielding assets - had never seemed easier or more rewarding. Investors in Japan, Europe and the US earned a tidy sum from $A deposits generating more than 5per cent and $NZ deposits more than 7per cent.

That tactic's clearly run out of puff where the $A and $NZ are concerned; rates here are at a standstill and likely to be cut over in fundamentally-poor New Zealand. Rates are rising in the US, Japan and Europe. Funding costs are higher. The rewards aren't what they used to be.

So why aren't there signs of distress in other asset classes whose values have been fattened by ample cheap money? Emerging market currencies have wobbled this month but the sell-off is relatively tame. Global equity markets are doing well. Equity market volatility, as measured by the Chicago Board Options Exchange's index, remains near decade lows. Commodity prices remain aloft. Corporate bond yield spreads over government bonds remain unusually tight.

There are specific reasons why the spasm's been contained to Down Under so far. First, rate cycles this end are well ahead of other nations. Growth is clearly slowing in New Zealand. Record amounts of $A and $NZ bonds held by foreigners are due to mature this year and going by the price action in the currencies, traders are betting the money's headed back north.

The speculative crowd, however, is making the most of one thing: momentum. This bunch of trend-followers tends to hop on one strategy en masse. Such an attitude begets excess. The herd's clearly doing its best to slam the $A under US70¢ - there's a chance stop-loss orders are clustered around that key level. Setting off those orders and engineering a steep fall in the currency would delight the mob that has, this month, pushed the net short position in $A futures to a record high. Being "short" a currency is effectively a bet that it will depreciate.

Of course, such an extreme position could also presage a sudden reversal in the $A's fortunes. There must be a fair few speculators out there feeling queasy about their large positions, especially if the $A doesn't oblige by going lower. They'll be quick to back out at the first sign things aren't going their way.

Will other markets feel the pinch of shrinking global liquidity? Yes. The free-lunch counter will eventually close. But, as things stand, global monetary conditions are still quite easy.

Global broad money growth, for instance, was running at about 10per cent year-on-year late last year, off a recent peak of about 15per cent in late 2003 but well up on 2000's 0.5 per cent. The main contributors to the explosion were Japan and the euro zone. Foreign exchange reserves have swelled markedly in recent years although, as UBS's strategists note, Japan and China's rate of accumulation has slowed significantly in recent months. Bank lending growth in the US, Japan and Europe has picked up strongly since 2004. And perhaps most importantly, UBS's team points out, real short-term rates in the G7 have edged higher very gently in the past few years and have just managed to drift above zero.

But there's a disturbing legacy of years of near-free money - the increasingly speculative cast to investment, even among individuals. In Japan, where households were famously conservative, margin trading in foreign currencies has boomed. But when you're handed free money, it's your duty to put it to work.

"Never have we had so much speculative money rushing around and much of it is in non-professional hands," says Westpac's Robert Rennie.

"The level of global liquidity is still so high. And Japanese mums and dads controlled 40 per cent of last year's capital movement out of Japan - that is a record. Money is sitting there looking for a home and it's becoming speculative. Part of this money may be more prone to panicking."

See, Risque business. Obviously all that speculative fervour is better left to the professionals. They know what they're doing. Keep the mums and dads out of it. Just as soon as they lose their dough.