Fyodor – thanks, so I was kind of right – there are arbitrage opportunities during some short period following a change in rates, but those windows rapidly close (and render the spreads during those windows null).

It’s still speculation though and not a clear arbitrage if I can be pedantic, Dan. If there is a sudden move in a market you will likely have to favor a side first and then later cover the other side.

In other words if you think a sudden hypothetical action by the RBA will cause rates to move more than the market thinks for a point in time you still have to buy/sell that side and cover later.

Clear arb opportunities in this day and age don’t really exist per se, especially with a global price being available for trades contracts.

We used to call it specutrage.

Morgan Stanley had the biggest desk in the country arbing currencies, with a bunch of people arbing the currency futures contracts vs the interbank market. They were stilted human beings. Everyone outside despised them. They were a despicable desk. And you know, there wasn’t a lot in it. The biggest arb was the Euro and the arber made around $3 million a year for the bank in doing just that. That wasn’t really a whole lot of money in the scheme of things showing that arb opportunities aren’t around a lot. Keep in mind that the markets have become more technologically driven too.

Except the libs stimulus would have been smaller and later

You can Dan as JC notes, you just have to take the risk or spend even more insuring yourself against it, which the average person probably isn’t up to (or game to). Despite this, you are probably essentially already taking a currency risk through a proxy if you are investing in geared companies that have done it or in companies whose earnings are not mainly in Aus dollars. This is bound to be the case if you have stocks in your superannuation.

Or am I wrong – will the exchange rates automatically move to close, or more than close, that differential? If so, why?

Those Catallaxy folk might cogitate on why Canada has taken sooo long for their recovery to gain strength and consequently very slow fiscal consolidation.

I was responding to Ross who asserted that Canada had a “a similar economy” to Australia (and that therefore their lower interest rates were somehow an indictment of Rudd/Gillard govt policy. You’ve now argued (quite persuasively) that Canada’s economy is very different from Australia’s i.e. much more exposed to the US.

BTW If the figures I cited are gross public debt I agree with Tel that they’re probably not very useful. The net public debt figures appear to be as follows:

Australia – zero net debt prior to GFC rising to an estimated peak of a miniscule 6% of GDP in 2012-13 (despite putative small federal surplus);

Canada – apparently around 14.9% of GDP shortly prior to GFC (2007) rising to an estimated 44% of GDP in 2011-12. Not horrendous but much inferior to Australia.

Now Canada’s demonstrably much worse performance than Australia on both unemployment and net debt (and no doubt just about any other measure) might well be due at least as much to its greater exposure to the US economy than Australia than to the fact that it implemented a much smaller GFC stimulus package. I guess it depends on one’s ideological predilections. I simply don’t know. What I do know is that it is nonsense to point to Canada’s lower interest rates as proof that its economic policies are/have been superior to Australia’s over to last 5 years or so. The figures if anything suggest the opposite.

Canada was whacked because of what Patrick pointed out. For instance all the American car and car component makers have assembly plants across border on that iceberg and it was pretty significant to the economy, so when the industry got hit in the US, the iceberg also took it on the chin.

The Canadian dollar is very peculiar to trade because you also have to have a partial view on what is happening in the US on a macro level to figure out where that thing is heading. A general unscientific rough rule of thumb that traders use is that you need to take about a 1/3 of one’s view in terms of what is happening in the US if you’re looking to trade Canadian stocks or the Can dollar.

Dan:

Sorry if this is a dumb question, but why aren’t Australian banks borrowing where it’s dead cheap, ie. overseas?

Banks don’t borrow straight US dollars, Euros or Yen convert them to Aussie dollars and lend it out as the currency exposure is far too big.

So in order to get around that there are several ways of hedging the currency exposure and converting the proceeds in Aussie Dollars.

If the exposure is short term, say, either side of 12 months, a bank will borrow US dollars and cover the exposure forward through the currency forward market.

If it’s longer than that they will use the currency swap market which is little more difficult as it uses up a larger amount of notional credit limits with other banks.

But there is no free lunch if that is what you’re thinking as the interest differential is always factored in that it will gross up the cost of borrowing at the prevailing rates in the domestic market. In other words you can’t borrow US dollars without a currency risk and if you don’t want the currency risk, you end up paying the Aussie dollar interest rates.

Generally obtaining funding through overseas borrowings is always more expensive than either the domestic terms markets or straight out deposits which is the least costly.

This index shows a little of what went on last year. It went from 20 basis points to 60 as the European crisis was raging. It’s the spread between US t-bills and the 90 day libor/Euribor.

This is also a good index to look at along with it US counterpart.

It tells you how stressed the capital markets are.

Canada, Public Debt:

65.4% of GDP (2006 est.)
— GFC —
84.0% of GDP (2010 est.)
83.5% of GDP (2011 est.)

Australia, Public Debt:

14.1% of GDP (2006 est.)
— GFC —
28.8% of GDP (2010 est.)
30.3% of GDP (2011 est.)

Dan, it isn’t a stupid question. But the main answer is that bank debt is not cheap anywhere! There is always a margin over the base rates and for banks lenders demand both high margins and high security.

Second reason is that they lend AUD and so if they borrow foreign money they need to swap into AUD and the difference usually catches up to them in what they pay on the swap rates.

Canada implemented a smaller GFC stimulus package than Australia, indeed around the size that Abbott (and before him Turnbull) now argue Australia should have done. Coincidentally or otherwise, Australia’s unemployment rate peaked at just on 6% around July 2009 whereas Canada’s peaked at 8.7% only a month or two later. As David points out, Canada’s unemployment rate remains at around 7.6% while Australia’s is at 5.1%.

Not coincidentally one might suspect, as at 2010 (CIA World Fact Book per Wikipedia, Canada’s ratio of public debt to annual GDP stood at 83.95% whereas Australia’s was at 20%.

Those who make Australia/Canada comparisons and draw conclusions in Canada’s favour are largely merely making themselves examples of cognitive bias in general and confirmation bias in particular.

Any explanation of short-term rate differences between countries is complicated. In the case of Canada, the simplest fact to point to is jobs: Canadian unemployment spiked above 8 per cent during the GFC, and the Canadian authorities cut the official short-term rate from Australian levels to bugger-all. And since Canadian official unemployment is still 7.6 per cent, short-term rates Canadian official rates have stayed low. (The difference between the two nations’ rates at the long end of the curve is much smaller – about 1.9 per cent for ten-year government money.)

The broader point is that in economies with inflation-targeting central banks, low interest rates tend to be a sign of weakness, not strength. Australia is booming. Canada is not.

One thing that might cause a bit of excitement for the RBA (and certainly the shock jocks) would be if people started taking out foreign currency loans for housing. This already happens commonly in some places in Euroland (for better and often worse), although curiously it seems almost unheard of with the local population here, and no banks seem to aggressively market it. However, if it did happen en masse, it’s not clear to me what the RBA could do about it.

Conrad, that was widely popular in the 80′s, adopted by lots of people and a disturbing number ended up as equivalent road statistics. Secondly the banks spent several years defending themselves against lawsuits (having actually lost some) and having the bad publicity of bankrupting far too many people. They won’t go near them as a product.

However a foreign currency loan is actually pretty easy to replicate if that is what you wish to do. Take out a loan and go buy an Aussie Dollar/US or whichever currency contract to equal the sum borrowed. Give or take fees etc it gets you to the interest rate of the currency you wish to borrow in.

My recommendation though is don’t do it. Carry trades, which is what it actually are, is a really silly way to try and make make or save some money.