Fallout from the Crash: Carry Trade and the AUD

An explanation for the crash that is gaining credence (according to Art Cashin) is a spike in the Yen before the crash caused a rapid unwinding of carry trade positions, an idea that may have first been noted by Trader’s Narrative. The Yen has the most reliably low interest rate for the cary trade, and fear of a spike in the US rates could move money out of USD carry and back into Yen carry. As the bond market is an order of magnitude beyond the stock market in size, Forex dwarfs bonds. A little carry goes a long way to whipsaw stocks.

We saw a bit of normalization of carry currencies Monday, but will this sustain? If the crash is the warning shot of a change across lots of bets that worked during the Hope Rally, a lot of positions need to be rotated, starting with the darling of the carry trade, the Australian Dollar (AUD).

A quick comment about the AUD in a ZH post on the crash caught my eye about the AUD. The post noted how markets stopped at the same time worldwide across almost every type of market including futures, bonds, gold and forex. How could this be if it were merely a glitch in a few stocks? And how could this happen so swiftly unless a substantial majority of all trading is in the hands of a very small number of firms who made the decision to freeze over just a few minutes? The markets came back around the same time, but a few lagged, and this raises a red flag:

Finally notice that the EURUSD and AUDUSD are slightly late to the game to recover. Although the auction resumes about the same time, they continue to print precipitously longer. This is all the confirmation of Cluesix’ AUD analysis I need. No one is talking about it today, but after Asia tonight they will; Asia (and even China) are next.

I dug up the Cluesix Report: The Case Against the AUD. It observes that the AUD is the most overvalued currency in a developed market, too high by 30%. It is highly dependent on financials and commodities, and commodities may be in a huge bubble echo. The Lucky Country’s real estate may be as much as 50% overvalued. Speculators and carry-traders are betting heavily on the AUD uptrend.

The carry-trade may be rapidly unwinding in the wake of the crash. The AUD will suffer the most.

Committing economic suicide won’t help: a few days before the crash, the the Rudd government announced a 40% tax on profits from its mineral resources, to get a “fairer share” of the natural wealth of the country. Reaction was negative to shock at the utter foolhardiness of the blunder from down under.

The Case Against the AUD

An Australian business man shared his thoughts on the Cluesix report with me (excerpted below the fold):

Currency: I think it is overvalued, but then I ask: against what – as does Cleusix. The fundamentals of the European economy do not suggest that the AUD is over-valued against the Euro or the USD. Even after 3 years Labour depredations, the Australian economy can be restored to strength relatively quickly and with less pain than Europe and the US.

China: I don’t trust official Chinese government figures, and I think they have a huge problems with loans to State owned companies, but anecdotal evidence suggests that the underlying strength of economy is undoubted.

Real Estate: Cleusix is right about property being overstated, but probably overstates the over-valuation. Land is more expensive in Australia for two reasons:

1. people want to live in capital cities and/or near the water; and
2. and is rationed by the government.

If there was a proper free market in land, the price would rapidly establish itself at more economic levels, but that will not happen ever.

Banks: Cleusix is correct in identifying problems with the finance sector. The major structural problem here is the “four pillars policy” which sees the four major banks as being protected from takeover by each other and by foreign banks. The result is a tight oligopoly where the banks move in lockstep. Currently they are all concentrating lending on residential mortgages which are “safe” but they will not lend to developers; the net effect is to choke the supply of residential units at the same time that they are increasing lending to residences.

Bubble: There is a housing bubble, the responsibility for which lies with the banks, the governments at all levels (Federal, state and local), and unfortunately the Reserve Bank, who through its rate setting orchestrates interest rate levels for residential mortgages – each bank simply adopts whatever increase in rates immediately, so there is no price competition amongst the banks.

If you allow for the basic cost of land, and over-hyping by the big four, I would put the over-valuation somewhere closer to 20%. Since the GFC the Big Four now control 90% of residential mortgages, and the government will not allow any of the Big Four to fail, any failure will be at the S&L level (10% of loans) and will have limited impact on the economy.

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