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By Rohan at Data Diary:

Leverage, like many of our hedonistic pleasures, can be a pernicious addiction.  With the benefit of hindsight the Great Moderation that met it’s demise with the onset of the GFC was as much a product of consistently rising debt levels as any other variable.  It has left the majority of the developed world with ‘too much of a good thing’.  For the system to reboot, leverage needs to retrench one way or another.

The carry trade has been a longstanding pillar in the creation and recycling of leverage through the global economy. So it’s a good place to explore how leverage is evolving in our post GFC economy.

The carry trade during the credit boom

Consider the following chart of some prominent carry trade pairs across the last decade:

While the AUD tends to be a high yielding currency against all-comers, in a relative sense the AUDUSD will more closely track demand in the commodities that Australia exports (that are generally priced in USD) than its counterpart AUDJPY. It’s notable then that across the entire period between the bursting of the tech bubble and the GFC, AUDJPY traded at a premium to AUDUSD. This outperformance is remarkable in the context that commodities were the beneficiary of strongly growing demand across this same period.

This relationship came to an end during the mass liquidation of 2008 – since that time, the AUDUSD has outperformed the carry trade driven AUDJPY.

The carry trade post-GFC

But like any good drug, leverage is proving hard to give up.  Witness how the recent attempts by the Fed and its compadres to resurrect the liquidity party have flowed through to these same currency pairs:

While the Fed’s quantitative easing program was in full swing, the AUDJPY once again outperformed its commodity linked peer, the AUDUSD. Note that within this microsm of government fuelled liquidity, China undertook its own massive stimulus package that encouraged stockpiling of commodities on a grand scale.  Still the AUDUSD played second fiddle.

So we come to more recent events.  Government stimulus has receded as a primal mover in fund flows.  Leading indicators are tipping over.  Risk markets are on edge.  And once again, AUDUSD has taken the lead over AUDJPY. Liquidity as a function of the carry trade is on a ebb.

Without the carry trade, fundamentals matter

In this environment, the macro trade dominates – the fundamental view determines the flows. Perhaps the decline in EURJPY in this post GFC environment is a sign of what the world might look like without the carry trade. It may be the precursor to the next round of deleveraging. Less vicious than the forced selling of GFC part 1 – but perhaps as difficult nonetheless.  We’re watching the AUDUSD closely for a lead.