Keep Calm and Carry Oz
Commentators and speculators alike heralded the end of the US-Iran war as a great risk-on opportunity. We saw implied volatility fall and positioning build in favour of a risk-on period for markets. However, aside from those preparations for a tailwind to markets, no such boost ever materialised. Ultimately, with the US Dollar significantly stronger, debt rallies fading and equities virtually unchanged since the signing of a ceasefire, it may not just be a false-start for a sanguine period in markets; it may be over before it started.
The denial of a risk-on period for markets has also been felt within FX. Alongside Warsh’s unexpected commitment to price stability, the lack of a relief rally in risk assets has staved off some selling-pressure in the US Dollar. Despite this, demand for emerging market currencies has remained strong. This is because the so-called carry trade, where investors benefit from long positions in higher yielding currencies funded by lower yielding currencies, remains in demand.
However, notable market participants have recommended to clients, or evidenced in their own positioning, a rotation away from Dollar-funded carry. This is particularly due to sticky and often rising US Dollar funding costs as well as uncertainty over spot gains in the Dollar. Instead, the Euro and the Australian Dollar have both emerged as viable replacement candidates. AUD may seem an odd choice given that it has seen the best performance against the Dollar amongst the G10 year-to-date. However, at an elevated spot price, vulnerability is building from a combination of declining commodity prices and a deteriorating trade balance. Therefore, spurred on by its relatively cheap funding costs, investors may begin sell AUD to fund such exposure to higher yielding emerging market currencies.
Discussion and Analysis by Charles Porter
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