Minyan Mailbag - Interest Rates
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
I have a question about interest rates. How can the U.S. rates be less than some other G7 countries (Australia, New Zeland etc.)?
A prudent bond fund manager would then buy Australian Dollar bonds, hedge the currency risk and still get much better performance in just short term T-bills..
This I understand as another form of carry trade, if leverage is employed...
Is it that I am missing something here and it is too simplistic? Or is it the way liquidity is powered into the system, wherein the big players play these kind of games and make free money?
When you compare interest rates "nominally" to other G7 countries, U.S. rates may look lower, but this does not include the cost of hedging currencies.
Let's take an example. The U.S. two year government bond yields 3.8% while the two year Australian government bonds yield around 5.6%. A U.S. investor can take his dollars, convert them into Australian dollars, and then buy the Australian bonds and earn 160 basis points more. Sounds like a good deal.
The problem is that the U.S. investor cannot spend the Australian dollars. When the bonds mature, she is going to want to convert them back into U.S. dollars. If the exchange rate between the U.S. dollar and the Aussie dollar doesn't change over the two years, she can do this and capture that 160 basis point differential.
So the investor is at risk over the two year period that the U.S. dollar will appreciate against the Aussie dollar. She obviously does not want to take that risk, so when she invests in the Australian bonds she enters into a "forward" currency contract to sell Aussie dollars (by the amount of principal and accumulated interest) to buy U.S. dollars two years from now.
She is now guaranteed to receive back the right amount of dollars that she sold initially to buy the Australian bonds. It just so happens that the "cost" of the currency forward contract exactly offsets the nominal interest rate differential between the two countries.
So it turns out that nominal interest rate differentials that exist between countries are offset by the cost of currency forward differentials, the cost of converting currency back and forth.
This does not account for real risks between countries that exist: if Australia is truly "riskier" than the U.S. than that will be a real differential.
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