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One of the reasons that currency markets are so appealing to both seasoned and first-time traders is that they are open 24 hours a day, five days a week, and gapping – which is sometimes evident in stock index markets – is extremely rare.
Also, spreads between the bid and offer prices in forex pairs like EUR/USD and GBP/USD are extremely tight, so there doesn’t have to be a great deal of movement for a trader to generate a quick profit (or loss).
With the advent of the financial crisis in 2008, and the monetary easing and stimulus methods employed by the US Federal Reserve and the Bank of England, the focus of many investors has shifted to alternative currency pairs in Asia, where interest rates are generally higher. However, one of the downsides to looking outside the main currency pairs is that dealing spreads are a little wider; for example in GBP/AUD it can be as high as 4 pips at 2.1950/2.1954.
One of the main gainers in this shift of capital eastwards has been currencies like the Australian and New Zealand dollar, as investors go in search of yield in order to maximise their returns away from currencies like the pound and the US dollar, which currently have negative real interest rates.
Negative interest rates are when the value of cash on deposit is exceeded by inflationary pressures in the economy, meaning that in real terms the value of your cash is eroded. The UK economy was a case in point in 2012, where despite ISA rates in the region of 3%, inflation was running in excess of 5%.
This clearly isn’t the case now, with inflation falling back close to zero, but with ISA rates also closer to zero along with inflation, the benefits of holding cash remain negligible, which means that the attraction of a higher rate of return always retains a certain pull factor.
So while the UK has base rates of 0.5%, and Australia still has interest rates in excess of that, the attractions of holding the higher yielding asset remain, even if they aren't as compelling.
This disparity does become less of a pull if interest rates are falling, which has certainly been the case in the Australian dollar, which has seen its main interest rate fall from 4.5% to 2% in the last three years. This has reduced the attraction of the Australian dollar in terms of the interest rate differential, causing outflows out of the Australian currency, back into sterling, and has helped push the pound up from levels around 1.55 back in 2012.
As with any currency transaction there is always a currency risk involved, especially if traders are looking at interest rate differentials, but recently this has been less of an issue even if short-term price fluctuations have been quite volatile.
In terms of the carry trade, investors buy Australian dollars and then put them on deposit for a fixed term, whether it's overnight, or longer term, to earn interest at the higher rate available at the time. To offset that they sell sterling, and then borrow sterling to fund the overdraft on their sterling holdings at the lower rate for the same period. This equates to a positive carry as they earn interest at the higher rate and pay interest rate at the lower rate.
When looking at entering a trade of this type it's also important to look at the long-term outlook for interest rates. For example, is it likely that the outlook for rate expectations in both Australia and the UK is likely to change in the short term? This becomes important when deciding whether to go long or short on a particular currency, as the shorting of a carry trade currency gives rise to a negative carry, which means you have to balance the risks of losing money on the carry with the likelihood of a strong down move.
Looking at economic data and the narrative of central bank meetings for the European Central Bank, Federal Reserve and People’s Bank of China is extremely important in this case. For example, the general consensus is that the Bank of England is likely to keep interest rates unchanged at their current historically low levels, but could look to raise them at some time within the next 24 months, despite current low levels of inflation in the UK.
It’s therefore important to look at the outlook for Australian interest rates over the next 6-12 months, as these seem more likely to move than UK ones at the moment. This means the spread or difference between the two interest rates is likely to be driven by Australian monetary policy, as opposed to UK monetary policy.
If inflationary pressures in Australia are low, speculation among economists could be that the next move in interest rates in Australia might be even lower, towards 1%, further narrowing the gap between Australian and UK rate differentials in favour of the pound.
This would further strengthen the pound against the aussie, but if there is a pickup in Chinese growth, to which Australia is particularly exposed, then disinflationary pressures could ease as well. As a result the pressure for a rise in rates could ease as well. This would mean that the next move in rates in Australia could well be higher, and not lower.
This perception would change the interest-rate differentials between the two in the futures markets, and the spreads would start to widen. This in turn would prompt profit-taking as traders buy their Australian dollars and sell back sterling to realise their capital gains.
Other currency pairs that can be traded this way include the New Zealand dollar against the US dollar, the pound or even the Swiss franc, where interest rates have also been cut to zero. Understanding how these foreign exchange flows work is extremely important to the novice and experienced trader alike.