Photographer: Brendon Thorne/Bloomberg

What’s Driving FX Isn’t Just Yield - It’s Reverse Carry

The search for capital appreciation is on.

This wasn't supposed to happen. The central banks of Australia and New Zealand lowered benchmark interest rates and their respective currencies promptly strengthened.

Traders puzzled by the way foreign-exchange markets are behaving should consider that potential for capital appreciation, in addition to yield, may be a significant driver of recent moves.

Investors are engaging in a type of 'reverse carry trade,' buying low-yield currencies for high-yield pairs and accepting small interest rate differential losses for potential large capital gains where central banks are cutting rates or buying more domestic bonds. Those  moves should push up the price of underlying assets and, in theory, outweigh small losses on interest rate carry.

Yield remains a deciding factor for investors, but currencies with potential capital gains to complement yields will likely be the most sought. This trend would help explain flows following recent rate cuts across the Pacific, with the Reserve Bank of Australia and Reserve Bank of New Zealand being the most prominent examples.

Source: Bloomberg

The New Zealand dollar jumped more than 2 percent versus the U.S. dollar after the central bank cut rates on Thursday, in part because markets expect another 25-basis-point cut as early as November.

A second quarter-point cut offers the dual attraction of 10-year bonds with yield of more than 2 percent and the promise of additional capital appreciation as the bonds gain in value. 

The Australian dollar has also gained about 2.5 percent since the RBA’s "clenched teeth" rate cut earlier this month.

The Aussie, kiwi, emerging-market pairs — and to a lesser extent the Canadian dollar, where rate cuts and capital-appreciation opportunities remain — may still gain against lower-yielding currencies like the greenback and British pound, where central banks are either done easing or have little room to ease further with rates close to zero.

Vincent Cignarella is an FX strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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