Tag Archive | "Safe Haven"

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Cyprus Sinks Euro, Russian Investors


The euro was dealt another blow over the weekend when the island nation of Cyprus needed emergency bailout funds to sustain the country’s banks. Residents of Cyprus did not wait for the political outcome and drained ATMs of all available cash. Meanwhile, the country declared Monday and Tuesday bank holidays, giving Parliament time to shape a bailout plan.

However, the 56-member Cypriot Parliament is as dysfunctional as a Parliament can get. No single party has a majority and three parties have already said they will not approve the proposed tax levy system suggested by Brussels over the weekend. This caused the expected Sunday vote to be postponed until Tuesday, prompting a run on ATMs.

The weekend plan calls for Cyprus to impose a tax on bank accounts in the country’s banks. This would raise a healthy portion of a 7 billion euros and would be added to another 10 billion euros furnished by the ECB. The country, long believed to be a primary source for money-laundering activities, has established itself as an attractive offshore safe haven because of its policy of tax-free savings.

Once preliminary resistance to the proposed levy was voiced, government authorities were swamped with dissenters. The original proposal called for imposition of a tax amounting to 6.7 percent on bank deposits under 100,000 euros and a tax of 9.9 percent on deposits over 100,000 euros.

Some officials immediately began talks of tax-free deposits in the range of 20,000 euros or less, a reduction to 3.0 percent on deposits less than 100,000 and an increase in the tax on deposits greater than 100,000 euros to 12.5 percent.

Joerg Asmnussen, a key ECB negotiator in Brussels over the weekend responded, “It is up to the government alone to decide if it wants to change the structure of the contribution (from) the banking sector. The important thing is that the financial contribution of 5.8 billion euros remains.”

While the intent of the levy is clear, the act may send waves of doubt to other offshore banking countries inside and outside the EU. Additionally, banks in countries like Spain and Italy may also feel pressure from concerned investors.

EU officials were firm that this was a one-off solution but the Cyprus crisis underscores the continued instability in the region’s banking industry. The euro and European equity markets fell sharply off the news. US equities opened lower but were staging a rally by midday.

Russians Burned

While Parliament considers various courses of action, central bank governor, Panicos Demetriaces asked the important question, “The most important question is what would happen the following day if the bill isn’t voted. What would certainly happen is that our two big banks would need to be consolidated. This doesn’t mean that they would be completely destroyed. We will aim for this to happen in a completely orderly way.”

The possibility of a banking collapse would weigh heavily on Russia whose investors have as much money on deposit in the country as all other international and national investors. Russia has been considering a 2.5 billion euro loan to help the country’s banks but has been slow to pull the trigger.

Many of Russia’s wealthiest investors have money in Cyprus banks. Russian President Vladimir Putin opposes the tax wholeheartedly describing it as, “unfair, unprofessional and dangerous.”

Half of the 70 billion euros in Cyprus banks are from internationals with the largest depositors being from Russia. According to Moody’s, at the close of 2012, Russian banks had $12 billion invested in Cyprus banks while private Russians had another $19 billion in the banks.

EU officials have said they expect Russia to extend the proposed 2.5 billion euro loan. If these funds are not forthcoming, the tax bite might well increase.

What markets are wary of is if this type solution could be implemented in other European banking sectors. The levy would be a blow to internationals who believe their money is safer in foreign banks. Cyprus made a determination to be a financial center where discretion rules and tax policy was most favorable to investors.

However, the bigger issue is that there is one more unexpected crisis in an unsettled economic area. Look for the euro to fall sharply in upcoming sessions.

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Investors Poised For Greece Exit


This week’s meeting of euro zone members in Brussels was another unproductive dance around the sticky issues of Greece, Portugal, Spain, Italy, Ireland, growth and austerity. There is a certain air of defiance in the euro zone as supporters of growth, led by France, square off against Germany and its austerity policy. In the front and center stage of the euro zone crisis stands Greece, a nation conflicted by heavy debt, massive unemployment, no central government, 5 years of recession and riots in the street.

In mid-morning Friday, the word from Brussels was to prepare for Greece leaving the euro zone and returning to its own currency. This possibility gained traction because of Germany’s resistance to euro bonds and because Greece is on the verge of defaulting on all its obligations, including agreements to repay bailout funding.  Both the IMF and Germany are adamant about Greece living up to its obligations.

By midday, the euro was at $1.2511 USD and trending below the $1.25 resistance level. The euro is at its 20year low. Many Forex advisers believe that if Greece is out of the euro zone, the euro will fall to the $1.23 level and finish the second quarter at $1.20 falling to $1.15 in quarter 3, 2012.

Euro uncertainty has boosted the dollar as a safe haven. Against a basket of currencies, the dollar held firm at 82.411, the highest level since 2010.

The euro zone unrest will affect US exports.  19 percent of US exports are delivered to members of the 27-nation European Union. Euro zone exports account for 13 percent of total exports. Euro zone members.

Deutsche Bank issued a statement indicating that in 2010, Europe comprises 25 percent of world trade. The continent is a major importer for both the US and China.

If Greece puts a government in place in June, it is very possible the country will default on everything. The country will run out of money and will have to print its own currency.  The country will be in internal chaos.

What did emerge from Brussels is a variety of ideas about surviving the exit and default of Greece. Contingency plans are already in the works.  The member nations are trying to shield Portugal and Spain.

However, the biggest challenge facing the region is investor confidence. Greece is in a vulnerable position.  The country has little leverage and a history of breached agreements. The country accounts for about 2 percent of the region’s GDP. The exit of Greece would have minor consequences for the US but larger ones for Germany, France and its allies.  If other nations follow Greece’s example, the euro zone could disintegrate. That would be a serious problem.

Today, CNBC reported that a large concern in the euro zone is the scarcity of investors. There is no confidence that the members can negotiate a balanced remedy involving both austerity and growth.

When it rains it pours. S&P downgraded five Spanish banks on Friday. At the same time, Banksia, a conglomeration of failing banks assembled by the government, said it needed 15 billion euros to stay afloat. A failure in Spain carries much more serious consequences than the failure of Greece and would most likely trigger a series of international defaults.

A crash of the European Union banks would cause a crisis larger than the fall of Lehman Bros.

 

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Swiss Franc is the Only Safe Haven Currency


According to conventional market wisdom, there are three safe haven currencies: the Swiss Franc, Japanese Yen, and US Dollar. It is to these currencies that investors flock whenever there is a crisis, or merely an outbreak of uncertainty, and for much of the period following the collapse of Lehman Brothers, the three were closely correlated. As you can see from the chart below, however, one of these currencies has begun to distinguish itself from the other two, leading some to argue that there is now only one true safe haven currency: the Swiss Franc.


What’s not to like about the Franc? It boasts a strong economy, low inflation, and low unemployment. Unlike the US and Japan, Switzerland is not plagued by a high national debt and perennial budget deficits. Its monetary policy has been extremely conservative: no quantitative easing, asset-purchases, or any other money printing programs with euphemistic names.

Ironically, the only thing that makes investors nervous about the franc is that it has already risen so much. Remember when it reached the milestone of parity against the dollar in 2010? Since then, it has appreciated by an additional 20%, and seems to breach a new record on an almost weekly basis. The same goes for the CHF/EUR and CHF/JPY. The President of Switzerland’s export association is expecting further gains: “Parity is a realistic scenario. Given the indebtedness of the eurozone and the strong attraction of the franc, the euro is likely to continue to lose value.”


Given that Swiss exports have surged in spite of (or even because of) the rising Franc, however, he has very little to worry about at the moment. As you can see fromt he graphic below (courtesy of the Financial Times), the balance of trade continues to expand, and has exploded in a handful of key sectors. To be sure, economists expect that this situation will eventually correct itself and are already moving to revise downward 2011 and 2012 GDP growth estimates. Then again, they made the same erroneous predictions in 2010.

The main variable in the Swiss Franc is the Swiss National Bank (SNB). Having booked a loss of CHF 20 Billion from failed intervention in 2010, the SNB is not in a position to make the same mistake again. In fact, SNB President Philipp Hildebrand has not even stooped to verbal intervention this time around, undoubtedly cognizant of the fact that he has very little credibility in forex markets.

At the same time, the SNB is not in any hurry to raise interest rates, lest it stoke further speculative interest in the Franc. Its June meeting came and went without any indication of when it might tighten. Interest rate futures currently reflect an expectation that the first rate hike won’t come until March 2012. Thus, the downside of holding the Franc is that it will continue to pay a negative real interest rate. The only upside, then, is the possibility of further appreciation. Fortunately, the SNB is unlikely to stop the Franc from rising, since it serves the same monetary end as higher interest rates. In other words, a more valuable Franc serves as a direct check on inflation because it lowers the cost of commodity imports and should (eventually) soften demand for Swiss exports.

It is possible that the Swiss Franc will suffer a correction at some point, if only because it rose by such a large margin in such a short period of time. On the other hand, given that its economy has proved its ability to withstand the Franc’s appreciation, it’s no wonder that investors continue to bet on its rise.

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Pound Stagnates, Lacking Direction


The British Pound has struggled to find direction in 2011. After getting off to a solid start – rising 4% against the US dollar in less than a month –  the Pound has since stagnated. At 1.625 GBP/USD, it is now at the same level that it was at five months ago. Given the paltry state of UK fundamentals, the fact that it still has any gains to hold on to is itself something of a miracle.


The Pound’s failure to make any additional headway shouldn’t come as a surprise. First of all, the Pound is not a safe haven currency. That means that the only chance it has to rise is when risk is “on.” Unfortunately, the Pound also scores pretty low in this regard. Annual GDP growth is currently a pathetic .5%, and is projected at only 1.8% for the entire year. Inflation is high, and both the trade balance and the current account balance are in deficit. Deficit spending has caused a surge in government debt, and there is a possibility that the UK could lose its AAA credit rating.

Investors might be willing to overlook all of this if interest rates were at an attractive level. Alas, at .5%, the Bank of England’s (BOE) benchmark rate is among the lowest in the world. Moreover, it isn’t expected to begin hiking rates for many months, and even then, the pace will be slow. Simply, the economy is too fragile to support a serious tightening of monetary policy. Interest rate futures reflect a consensus expectation that rates will be only 75 basis points higher one year from now.

If that’s the case, why hasn’t the Pound crashed entirely? To be fair, the Pound is losing groroundround against both the euro and the franc, the former of which has it bested in economic grounds while the latter is cashing in on its status as a safe haven currency. On the other hand, the Pound is still up for the year against the US dollar and Japanese Yen, both of which are also safe haven currencies.

It could be the case that the Pound is simply not the ugliest currency, since all of the charges that can be leveled against it can similarly be leveled against the dollar. Head-to-head, it’s actually quite possible that the Pound still wins, if only because its interest rates are slightly higher than the US. Or, it could be the case that investors still believe the BOE will come around and begin hiking rates. After all, at the beginning of the year (when by no coincidence, the Pound was still rising), expectations were that the BOE would have already hiked twice by this time, bringing the benchmark to a level that would make the Pound attractive to carry traders. While the BOE hasn’t followed through, carry traders may be sticking around, since the opportunity cost of holding the Pound is basically nil.

As for whether the Pound correction (that I first observed last month) will continue, that depends entirely on the BOE. Unfortunately, there is very little reason to believe that the UK economy will suddenly pick up, and hence very little reason to expect the BOE to suddenly tighten. At some point, earning .5% interest on Pounds will become unattractive to investors. Until that day comes, that might stick with the Pound out of sheer inertia. While the Pound may hold its value for this reason, I don’t think it has any hope of appreciating further this year.

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How to Trade the Franc-Yen-Dollar Correlation


Last week, the Wall Street Journal published an article entitled, “Currency Correlations Lose Their Way for Now.” My response: It depends on which currencies you’re looking at. I, too, recently posted about the break-down of multi-year correlations, specifically involving the Australian Dollar and the New Zealand Dollar. However, one has to look no further than the Swiss Franc to see that in fact currency correlations are not only extant, but flourishing!

I stumbled upon this correlation inadvertently, with the intention (call it a twisted hobby…) of refuting the crux of the WSJ article, which is that “Standard relationships between risk appetite and safe havens, and yields and risky assets, are lost as investors appear to scramble in their efforts to adapt to a new direction.” Basically, the author asserted that forex traders are searching for guidance amidst conflicting signals, but this has caused the three traditional safe haven currencies to behave erratically: apparently, the Franc has soared, the Yen has crashed, and the US Dollar has stagnated.


I pulled up a one-year chart of the CHFUSD and the CHFJPY in order to confirm that this was indeed the case. As you can see from the chart above, it most certainly is not. With scant exception, the Swiss Franc’s rise against both the US Dollar and the Japanese Yen has been both consistent and dependable. The only reason that there is any gap between the two pairs is because the Yen has outperformed the dollar over the same time period. If you shorten the time frame to six months or less, the two pairs come very close to complete convergence.

In order to provide more support for this observation, I turned to the currency correlations page of Mataf.net (the founder of which I interviewed only last month). Sure enough, there is a current weekly correlation of 93% [it is displayed as negative below because of the way the currencies are ordered] between the CHFUSD and the CHFJPY, which is to say that the two are almost perfectly correlated. (Incidentally, the correlation coefficient between the USDCHF and the USDJPY is a solid 81%, which shows that relative to the Dollar, the Yen and Franc are highly correlated). Moreover, if Mataf.net offered correlation data based on monthly fluctuations, my guess it that the correlations would be even tighter. In any event, you can see from the chart that even the weekly correlation has been quite strong for most of the weeks over the last year.


The first question most traders will invariably ask is, “Why is this the case?” What is causing this correlation? In a nutshell, the answer is that the WSJ is wrong. As I wrote last month, the safe haven trade is alive and well. Otherwise, why would two currencies as disparate as the Franc and the Yen (whose economic, fiscal, and monetary situations couldn’t be more different) be moving in tandem? The fact that they are highly correlated shows that regardless of whether they are rising or falling is less noteworthy than the fact that they tend to rise and fall together. Generally speaking, when there is aversion to risk, both rise. When there is appetite for risk, they both fall.

The superseding question is, “What should I do with this information?” Here’s an idea: how about using this correlation for diversification purposes? In other words, if you were to make a bet on risk aversion, for example, why not sell both the USDJPY as well as the USDCHF? In this way, you can trade this idea without putting all of your eggs in one basket. If risk aversion picks up, but Japan defaults on its debt (an extreme possibility, but you see my point), you would certainly do better than if you had only sold the USDJPY. The same goes for making a bet on the Franc. Whether you believe it will continue rising or instead suffer a correction, you can limit your exposure to counter currency (i.e. the dollar and yen) risk by trading two (or more) correlated pairs simultaneously.

In the end, just knowing that the correlation exists is often enough because of what it tells you about the mindset of investors.  In this case, it is just more proof that they remain heavily fixated on the idea of risk.

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Swiss Franc at Record Highs


This month, the Swiss Franc touched a record high against not one, but two currencies: the US dollar and the Euro. Having risen by more than 30% against the former and 20% against the latter, the franc might just be the world’s best performing currency over the last twelve months. Let’s look at the prospects for continued appreciation.


As I wrote on Monday, the Swiss Franc has been one of the primary beneficiaries of the safe haven trade. With each spike in volatility, the Swiss Franc has ticked upward. Due to monetary and fiscal stability as well as political conservatism, investors have flocked to the Franc in times of crisis. Of course, the Japanese Yen (and the US dollar, of late) has also received a boost from this phenomenon, but to a lesser extent than the franc, as you can see from the chart above.

Personally, I wonder if this isn’t because the Swiss economy is significantly smaller than that of Japan and the US. In other words, its capacity to absorb risk-averse capital inflows is much smaller than that of Japan and the US. For example, the impact of one million people suddenly rushing out to buy shares in IBM stock would have a much smaller impact on its share price compared to a sudden speculative flood into FXCM. The same can be said about the franc, relative to the dollar and yen.

Ironically, the franc is also rising because of regional proximity to the eurozone. I use the term ironic to denote in order to signify that the franc is not being buoyed by positive association with the euro but rather because of contradistinction. In other words, each time there is another flareup in the eurozone sovereign debt crisis, the franc typically experiences the biggest bounce because it is the easiest currency to compare with the euro. In some ways, it is basically just a more secure version of the euro. This phenomenon has intensified over the last month, as the euro faces perhaps its most uncertain test yet.

It is curious that even as investors have gradually become more inclined to take risk, that not only has the franc held its value, but it has actually surged! Perhaps this is because it is expected that the Swiss National Bank (SNB) will soon hike interest rates, making the franc both high-yielding and secure. To be sure, some analysts think that the SNB will hike as soon as June. The fact the the economy has continued to expand and exports have surged in spite of the strong franc only seems to support this notion.


On the other hand, inflation is still basically nil. And just because the Swiss economy can withstand an interest rate hike hardly provides adequate justification for implementing one. Besides, the SNB hardly wants to give the markets further cause to buy the franc. If anything, it may even need to intervene verbally to make sure that it doesn’t rise any higher. Thus, “The median forecast among economists is for a rate increase in September.”

In short, I think the franc is overbought against the dollar. In fact, you can see from the most recent Commitment of Traders data that speculators have been net long the franc for almost an entire year, and it seems inevitable that this will need to reverse itself. On the other hand, the franc probably has more room to rise against the euro. The takeaway here is that it is less important to know where you stand on the franc in general and more important to understand the cross currency.

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Risk Still Dominates Forex. The Dollar as “Safe Haven” is Back!


Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.


Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.

Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.

Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

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Can the Australian Dollar Hold on to Record Gains?


The volatility of the last couple weeks has manifested itself in some unbelievable outcomes. In this post, I want to focus specifically on the Australian Dollar. When the Japanese disasters struck, the Aussie immediately tanked, as investors jettisoned risk and moved towards safe haven currencies. Only days later, it inexplicably rose 5%, en route to parity and a 28-year high against the US Dollar. The question is: will the Aussie hold on to these gains, or will it return to earth as soon as the markets come to terms with the misalignment with fundamentals?

The Australian Dollar remains buoyant largely because of interest rate differentials. Basically, Australia boasts the highest benchmark interest rates (4.75%) in the industrialized world, and investors are betting that it will rise further, perhaps to 5.5% by the end of 2011 and even higher in 2012. Given that the other G7 Central Banks probably won’t hike for a couple more quarters – and even then, rate hikes will be gradual and restrained – it’s only natural that yield seekers are flocking to the Aussie.

However, it seems possible that the markets have gotten ahead of themselves in presuming an airtight case for further rate hikes. While Australian inflation is somewhat high (2.7%), it has actually moderated slightly over the last six months. In addition, the rising Australian Dollar will help to mitigate inflation and hence make it less likely that the Reserve Bank of Australia (RBA) will hike rates. (How ironic that the markets’ bet on higher interest rates in Australia actually makes it less likely that those rate hikes will actually take place!).

Moreover, the domestic Australian economy isn’t performing as well as some people think. It is true that an investment boom in mining and a surge in commodities prices have provided an economic windfall. On the other hand, the strong Aussie has undermined strength in the manufacturing sector, the housing market is poised for correction, and the summer flooding will crimp at least .5% from 2011 GDP.

In fact, not only is it not guaranteed that the RBA will hike rates, but some analysts think it’s possible that the RBA will cut its benchmark cash rate before the end of the year. At the very least, analysts need to double check their assumptions and re-jigger their interest rates models.  Given that the Australian Dollar is primarily being supported by expectations for higher interest rates, that also means that investors to scale back their forecasts for the Australian Dollar.

Personally, I think that a bubble is beginning to form in currency markets, at least in certain corners of it. Due to commodity prices and relatively high interest rates, the Aussie is certainly one of the more attractive major currencies at the moment. At that same time, that it has risen so fast in the last few years – and especially in the last few weeks – strikes me as fundamentally illogical. At this point, its rise has become self-fulfilling; investors want it to rise, and so it does.

At this point, there are two possibilities. Either the markets will wait for fundamentals to catch up with the Aussie, and it will hover around parity or appreciate slightly, or investors will recognize that it has appreciated too much too fast, and its correction will become one of the major events in forex markets in 2011.

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Forex Volatility Rises from Multi-Year Lows


In the last month, volatility in the forex markets touched both a two-year low and a one-year high. In the beginning of March, volatility essentially returned to pre-credit crisis levels. One week later, when the earthquake and inception of the nuclear crisis in Japan, volatility surged 40%. While it has since resumed its downward path, investors are still bracing themselves for continued uncertainty.


The carry trade has perhaps born the brunt of the volatility spike. The carry trade depends on interest rate differentials – as opposed to currency appreciation – to drive profits, and  thus demands stability. When the markets become choppy and exchange rates spike wildly in one direction or another, it makes the carry trade significantly more risky. Hence the paradoxical rise of the Japanese Yen to a record high following a series of crushing disasters, as highly leveraged traders moved to unwind their Yen-short carry trades.

Likewise, high volatility should spur demand for so-called safe haven currencies. If only it were clear what constitutes a safe haven currency. Traditionally, that would send the US Dollar, Swiss Franc, and Japanese Yen upwards. In this case, the Franc has benefited most, followed closely by the Yen. The Dollar spiked against emerging market and high-risk currencies, but hardly budged against its G4 counterparts. Could it be that the Dollar’s multi-year positive correlation with volatility has (temporarily?) abated.

With regard to strategy, currency traders have a handful of choices. If you believe that volatility will continue declining or remain stable, you’re probably going to go long emerging market and high-yielding currencies, and short one of the safe-haven currencies, all of which are quite cheap to borrow. The main risk of such a strategy, of course, is that volatility will once again spike, in which these safe have currencies will rally.


If you think that the ebb and volatility isn’t sustainable, then you’re probably going to bet on the Franc, Dollar, or Yen. As I wrote in an earlier post, I think the Yen could theoretically appreciate in the short-term, but actually remains quite risky over the long-term. Despite the best efforts of the Swiss National Bank, the Franc will probably continue appreciation. Economically and monetarily, it is in an excellent shape. Besides, the fact that the supply of Francs is intrinsically small means that even modest capital inflow often translates into a big jump in its its value. As for the Dollar, it is now the most popular currency to short. It remains a safe choice and a good store of value, but probably won’t deliver the returns that safe-haven strategists have come to expect.

From a practical standpoint, you may also want to consider reducing your leverage. As everyone knows, high leverage increases profits but also magnifies losses. In the current environment of heightened volatility, leverage also magnifies risk. Either way, you may also want to consider hedging your exposure, by trading a basket of currencies and/or through the use of options.

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Oil Prices and the FX Conundrum


I haven’t blogged about oil prices in quite some time. After prices collapsed in the wake of the financial crisis, there really wasn’t much to talk about. However, the price of crude oil has risen more than 50% since June, and it now seems to be at the forefront of investor consciousness. Currency market watchers, in particular, need to brace themselves for the nuanced and sometimes contradictory ways in which oil prices bear on exchange rates.


Under normal conditions, the impact of rising oil prices on the currency markets is somewhat straightforward. First of all, the currencies of oil-exporting countries will typically experience some degree of appreciation. In addition, since oil contracts are still mainly settled in US Dollars, oil prices and a weak Dollar tend to go hand-in-hand. Second, insofar as rising prices drive inflation, the same can be said for Central Banks that are proactive in tightening monetary policy. As real interest rate differentials widen, (risk-averse) capital will naturally gravitate towards the highest returns.

The same logic cannot be applied to the current situation, however. That’s because this time around, oil prices aren’t being driven by economic fundamentals and rising demand, but rather by concerns over supply. You don’t have to be an expert to understand the connection between the continuing Mid East political crisis and oil futures. In the last two weeks alone, prices have risen a whopping 15% and show no sign of abating, as long as tensions linger unresolved.

From that standpoint, you might expect the political tensions to drive safe haven flows to the US Dollar. On the other hand, you would also expect that the resulting high oil prices might crimp the US economic recovery, and cause traders to punish the Dollar. However, you also need to consider that rising oil prices might also cause the Fed to eventually raise interest rates, or at least rein in QE2, which would be Dollar-positive.

Enough with the theory; let’s look at what’s happening in reality! The Canadian Dollar and Australian Dollar are rising, even though oil accounts for only 7% of the  former’s exports, and is a nil factor in the latter’s economy. It looks like forex investors are confusing oil prices with commodity prices, which are also rising, but at a much slower pace. In addition, since higher energy prices will probably erode economic growth in energy importing countries, this could actually hurt some commodity currencies over the long run.

The US Dollar has fallen across-the-board. While Ben Bernanke has insisted that the impact of higher energy prices on the US economy will be minimal, the markets are either taking the opposite view or are punishing the Dollar for the Fed’s dovishness. In other words, if Bernanke isn’t concerned about oil, he probably won’t cap QE2, and certainly won’t steer any interest rate hikes in the near-term.

Meanwhile, the European Central Bank (ECB), whose mandate is tilted towards maintaining price stability, has begun to voice concerns about the impact of rising commodity prices on inflation. Consumer and producer price indexes are rising across the Eurozone, and members of the ECB have suggested that they will take a proactive stance in preventing them from spurring inflation.

In conclusion, while both the EU and the US are net oil importers, the Euro is poised to outperform the Dollar, all else being equal. In addition, as long as the mid east political protests don’t drive further instability and contribute to any major supply shocks (especially in Saudi Arabia and Iran), there won’t be any impetus towards safe-haven capital flows. At the same time, while I don’t pretend to be an expert on oil prices, I would expect prices to stabilize and for a handful of minor corrections to materialize in the fx market. Traders are still looking for an excuse to short the Dollar in favor of, well, everything else, but sooner or later they will have to accept the limits of this trade, high oil prices or not.

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