Answer:
The Australian dollar is expected to depreciate relative to the U.S. dollar due to interest rate parity with higher Australian interest rates. Expected currency appreciation affects investment yields, potentially decreasing bond yields as the returns from currency appreciation are considered.
Step-by-step explanation:
If interest rate parity holds and the U.S. interest rate is 11 percent compared to Australia's 12 percent, it would generally suggest that the Australian dollar is expected to depreciate relative to the U.S. dollar. This is because higher interest rates often attract more foreign capital, leading to an appreciation of the domestic currency. However, with interest rate parity, the forward exchange rate would adjust so that investors are indifferent to investing at home or abroad, considering the expected changes in exchange rates. In this scenario, since Australia has a higher interest rate, without any arbitrage opportunities, the forward rate would forecast a depreciation of the Australian dollar to offset the higher interest rate.
When a country's currency is expected to appreciate, this can impact the yields on investments such as government bonds. As the demand for the appreciating currency increases, due to higher expected returns on investments, this can lead to a decrease in bond yields. Investors would be willing to accept a lower yield because the expected currency appreciation is factored into their total expected return. Conversely, if a country's currency is expected to depreciate, investors might require higher yields to compensate for the expected loss in currency value.