The Australian dollar's days as a carry currency could be numbered if the European Central Bank disappoints and takes only incremental action on Thursday at its highly anticipated policy meeting.
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With the US Federal Reserve and the Bank of England firmly expected to trace a path to raising interest rates next year, an important source of oxygen for the popular carry trade is poised to dry up. The carry, where investors borrow low to invest in higher-yielding assets elsewhere, has helped propel the Australian dollar to levels the Reserve Bank of Australia says exceed fair value.
Trading softer in the Asia session on Tuesday ahead of the release of Australian economic growth figures on Wednesday and a speech by Reserve Bank of Australia governor Glenn Stevens, the Australian dollar was fetching US92.88¢.
The Japanese yen was the big mover of the day, dragging regional currencies lower on the back of anticipated pension scheme reform that could dent demand for Japanese bonds which is negative for the yen.
The Australian exchange rate is a source of frustration for the RBA, which declared the currency "remains above most estimates of its fundamental value" in its latest policy statement.
"It's the extent that global policymakers maintain loose monetary policy, all else being equal, that's going to see carry currencies supported," Barclays foreign exchange strategist Hamish Pepper said. "We don't see that being the case for the BOE. We think they'll hike rates at the end of the year, we don't think that's the case for the Fed either. The days are numbered for carry currencies to do well."
However, in the meantime, low volatility and an inflection point for global policy has created a benign environment that has supported Australian dollar strength.
Safety currency
"Even though Australia doesn't offer perhaps the highest yield in the world, it is triple-A rated and if you look at its interest rate differential on a risk-adjusted basis, it actually starts to look OK," Mr Pepper said.
National Australia Bank global co-head of FX strategy Ray Attrill highlighted the significance that markets were still characterised by low volatility and said a downturn in the CBOE volatility index had supported the currency through August.
"The Aussie dollar refuses to fall out of the range it's been in of US92¢ to US95¢," he said. "The persistence of the low volatility environment is definitely part of the story there."
He also said Asia emerging market currencies were performing strongly in the absence of compelling economic data, suggesting liquidity was still abundant. "Asian emerging market currencies have bucked the trend of a stronger US dollar. They still seem to be attracting the remnants of [quantitative easing] liquidity flowing into high yielding markets," Mr Attrill said.
"In a way, I would have thought Asian currencies would be struggling to attract foreign capital against a backdrop where China's not terrific."
In China on Monday officials said that the purchasing managers index came in at 51.1 in August from 51.7 in July, indicating a slowing in manufacturing.
European challenge
Meanwhile, the ECB is under pressure to deliver a bold and swift response to arrest Europe's sliding fortunes at its next meeting on Thursday, leading to calls for more stimulus.
In June, ECB president Mario Draghi pre-empted further action by saying his work was not done yet after the central bank sensationally moved to negative deposit rates and cut the European Union's main refinancing rate by 0.1 of a percentage point to 0.15 per cent.
Not all experts are convinced the ECB is on the cusp of Fed-style quantitative easing, including Gabriel Stein, a London-based economist at consultant Oxford Economics.
"The ECB attitude has been 'God, please make the US economy grow so strongly that the Fed will raise interest rates, strengthen the dollar and weaken the euro so we don't have to do any QE [quantitative easing]," he said. "Interest rates are already ultra low. Spanish 10-year bonds yield less than US treasuries. If anybody believes Spain is a safer investment than the US, I am sure there are a lot of other things that could be sold to you.
"You get to the point where the only point to implement QE would be for the announcement effect and possibly because it would help to weaken the euro."
He added the ECB was more likely to wait to gauge the success of its first targeted long-term refinancing operation which takes place this month.
