Photo: Douanes Francaises/Getty Images

Last week the Commonwealth Bank’s currency team released a note highlighting 8 reasons why the Australian dollar didn’t fall after the RBA cut rates.

One of those reasons, according to CBA’s chief currency strategist Richard Grace, was that “Australian interest rates are still relatively attractive given low rates in the US and negative rates in Europe”.

That is certainly true. Australian 10-year bonds are sitting at 1.969% in a world with more than US$10 trillion in sovereign debt which yields a rate below zero.

But that comment, and a chart which the RBA used in the recent quarterly Statement on Monetary Policy, reminded me of the limits of interest rate differentials in the context of the impact of the bond spread on global investors.

The RBA said in the SoMP:

Yields on 10-year Australian Government Securities (AGS) reached a historic low of 1.82 per cent in early August alongside the decline in global bond yields. AGS yields have continued to be largely influenced by movements in US Treasuries, although the spread between the two has narrowed in recent months.

That spread narrowing has been a reflection that Australia recently joined the global low inflation club with the RBA, and bond traders pushing rates lower as a result.

But the fall in the spread is important to the Aussie dollar’s future. Let me explain.

When I was head of currency strategy at the NAB I used to wander all over the globe and talk to the big money managers, and central banks who were NAB’s clients and big investors in the currency and bond markets.

One thing that struck me then, as it does now, is that Australia, the Aussie dollar, and Australian commonwealth government bonds are off index bets for many investors.

That is, they buy these assets in size that is far greater than Australia’s actual weighting in global bond, and other, indexes to which they benchmark their return performance.

That means that Australia, the Aussie dollar, and Australian bonds have to earn their spot in the portfolio over and above the much smaller weight in the index. It’s also why most big investment houses have a “dollar bloc” specialist.

Anyway, long story short – investors need a pick up to buy Australian bonds and Aussie dollars over and above US bonds, and the rest of the dollar bloc (NZD, CAD and to a certain extent GBP).

When that pick-up is no longer there, the reason for owning Australian bonds – and the Aussie dollar – evaporates.

It’s one of the reasons the RBA has consistently thought when the Fed eventually starts raising rates, the Aussie dollar will fall. It expected US bond rates to rise thus making the US, not Aussie, dollar the most attractive place for global investors to hold “dollar” bets.

But so far the Fed has been reluctant to drive rates in the US higher at their own forecast track. So in a world of low rates and marginal returns, even at decade lows, there is still a material pick up in holding Australian bonds.

But should the Fed hike again, or should non-farm payrolls keep printing stronger and put upward pressure on US rates, that margin will close.

And eventually if US 10s push higher than their Australian government equivalent, there is every chance a switch will flick and a large amount of support for the Aussie dollar will switch across to the US.

That just might be the catalyst for the still numerous calls for the AUDUSD to collapse below 70 cents.

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