G10 FX Weekly – Euro safe-haven?

by: Georgette Boele

G10-FX-weekly-27-August-2015.pdf (316 KB)

The euro as safe haven currency? No it’s a funding currency

The US dollar is still a safe-haven currency with a cyclical touch…

…while the yen is a safe-haven and funding currency

We have made some adjustments to our near-term forecasts

Euro as safe-haven currency?

This week the euro strengthened sharply against the US dollar during the turmoil on equity markets on so-called Black Monday. This triggered reports that the euro is now a safe-haven currency. We disagree with this interpretation. Below we explain why.

What are safe haven currencies?

Safe-haven currencies are currencies that investors flea to when they are concerned about a very negative development in financial markets. Therefore, these currencies have a strong tendency to rally when investor sentiment deteriorates (for example on higher equity volatility and Emerging market CDS spreads). In addition, they have a strong negative relationship with 10y US Treasury yields. US Treasury bond yields in general drop in case of risk aversion. Moreover, they tend to rally when domestic stock markets tank. They tend to be widely traded. They have a high share in international currency reserves. Furthermore, these are currencies of countries that have deep and liquid financial markets.

Is the euro a safe-haven currency? No it’s a funding currency

Has the euro risen because of safe-haven flows? We don’t think so. The EUR/USD has risen for two reasons. First for some time now, financial markets were short the euro and long US dollar because of monetary policy divergence. Investors had set up carry trades with the euro as the funding currency.  In general, in periods of positive investor sentiment, investors build up positions that lock in interest rate spreads. For example they short a currency with low official rates and of countries with central banks that are no-way close to tightening monetary policy. On the other hand, they search for currencies that pay a higher interest rate. The choice of funding or carry currency depends to a high extent on the behaviour of its central bank, the trend in a currency and the currency volatility. If this combination is not attractive there is a lower tendency to set up carry trades. When investor sentiment deteriorates the opposite happens. Therefore, the euro rallied versus the US dollar because some of these short positions were closed.

Second, the US dollar has had some cyclical weakness. When US inflation came in below-expectations and FOMC minutes were seen as more dovish investor sentiment sharply scaled back expectations about Fed rate hikes this year. As a result the US dollar fell versus the euro.

In short, the reason for the EUR/USD rise on Monday was a cut back of positions (unwinding of carry trades) combined with cyclical US dollar weakness. In our opinion, safe haven demand has not been behind the surge in EUR/USD.

Is the US dollar still a safe-haven currency?

We judge that the US dollar is still a safe-haven currency but the US dollar’s character is versatile and can shift to being more cyclical in certain periods. The US has the deepest financial markets and the US dollar is the most liquid currency. In addition, it is the number one currency in foreign exchanges reserves. It was the ultimate safe-haven currency at the height of crises where the global financial system is being questioned, like it the 2008 global liquidity crisis. Its behaviour in relation to other financial markets is less clear than that of the Japanese yen. The dollar’s character is more versatile. It can also behave like a cyclical currency and react on Fed rate hike expectations and the strength of the economy as we have seen now for quite some time.

Japanese yen is a safe-haven and funding currency…

Currently the Japanese yen is the ultimate safe-haven currency in terms of behaviour. It has a strong positive relationship with equity volatility, and strong negative relationships with Nikkei and 10y US Treasury yield (see graph below). What is more, the yen is a liquid currency and Japanese financial markets are deep. In addition, the yen is also a funding currency because the monetary policy by the Bank of Japan. During the recent market rout, the yen was the clear outperformer. This outperformance was mainly due to the closing of yen short positions. However, its safe-haven status has also given support.

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In the future, the character of the yen could change. For example if the Bank of Japan were to start a more aggressive tightening cycle than other major central banks (now unthinkable), the yen will likely more behave as the US dollar currently behaves. This is because it would because a safe-haven currency with a cyclical touch instead of a safe-haven and a funding currency. In such an environment, the yen would weaken in environments of modest risk aversion and strengthen if investor sentiment improves or if there is a global full-blown across markets panic.

Adjustments in near-term forecasts

The recent market rout has resulted in an adjustment in our near-term currency forecasts (September). Although our base case is for a Fed September rate hike, the risk has increased significantly that the Fed delays further. Even if US economic data continue to be strong and the Fed would hike interest rates in September, parity in EUR/USD will unlikely be reached in September. Therefore, we have made some adjustments. The risk has also increased that the ECB may step up QE. However, we will expect to see parity in EUR/USD if investor sentiment improves, US data come in strong as we expect and monetary policy divergence is on again. As a result, we keep our parity call for December.

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