Risky returns or safe havens
How investor sentiment can impact your exchange rates
Markets are betting on a 2021 economic upswing
2021 is shaping up to be a year of optimism as stimulus packages and vaccine rollouts supercharge economies. It’s why stock markets have been steadily rising, and that positive investor sentiment has a similar impact on certain currencies.
Currently the financial markets are betting on growth stocks, and backing currencies linked to economic upswings in what financial markets refer to as a “risk-on” environment.
Commodity currencies come to the foreIn the currency world, “risk” or commodity currencies are aligned to rising economic activity driving demand for raw materials like iron ore and oil. The Australian dollar (iron ore) and the Canadian dollar (oil), tend to rise when prices for those commodities are high. The Aussie is recently hit 80 US cents, a point not reached since 20171, driven by bumper exports of iron ore at high prices sent to China to meet their demand for steel. Similarly, the Canadian dollar, or loonie, reached 3-year highs against the US dollar2 as the oil price (Brent crude) bounced back from its pandemic low of $20.37 to $64.81.
Commodity currency indicators to watch
If you are trading these currencies, keep an eye out for commodity price forecasts. Currently, Goldman Sachs predicts that we are entering a commodity “super-cycle”3 which will push up aligned currencies. It can affect adjacent countries, such as New Zealand, whose dollar is strongly correlated to the Aussie.
Conversely, slowing growth will put downward pressure on commodity currencies, as demand for commodities, and the products they become, dries up. That will typically cause a rotation to safe-haven currencies like the USD (see below).
The share market is the surest barometer of slowing growth. When investors understood in March 2020 the coronavirus would have major economic repercussions, the US S&P500 dropped 30% in a month. With investors spooked, they fled to US treasuries (safer bond investments) and the US dollar, pushing up the currency. In that same month, the commodity-correlated Aussie dollar fell 15% against the greenback.
Other factors can work against commodity currencies. China’s fractious relationship with Australia has led to heavy tariffs on wine, beef and grains4, and while iron ore has been spared so far, if the trade relationship soured further and impacted iron ore, the Aussie would be likely to suffer.
Oil is particularly vulnerable to geopolitics, and currencies linked to oil exports — like the Canadian loonie — likewise. Challenges affecting members of OPEC (Organisation of the Petroleum Exporting Countries) can cause the oil price to swing wildly as it did in 2018-19 when the price of crude rose 20%, crashed 40%, then rebounded 25% as fears of US sanctions on Venezuela and Iran were met by oversupply by Saudi Arabia and Russia.5 Armed conflict in or between member countries is also a factor that can quickly move markets.
Why investors seek safe havens
All the above factors that affect “risk” assets can have a converse impact on “safe haven” investments that offer protection from market downswings.
In times of uncertainty, investors sell off risky shares and switch to defensive stocks or government bonds; they repatriate money from emerging market equities and currencies; and they sell out of positions in growth commodities like iron ore and put them into commodities like gold.
The US has long been regarded as a safe-haven destination. As the largest economy in the world, it is better equipped to ride out downturns. Its financial system is deep and liquid and the US Federal Reserve has broad powers and the balance sheet to prop up the economy with tools like Quantitative Easing (QE). Finally, the US dollar is the global reserve currency, meaning whatever drama is taking place, trade is still conducted primarily in USD.
Another safe-haven currency is the Swiss franc. It has a stable government and financial system, and its independence from the European Union keep it relatively immune from any negative events in the region. The Japanese yen is also seen as a safe alternative, evidenced by its sharp rise when the stock market tumbled in March 2020 on coronavirus fears and Saudi Arabia launching an oil price war.6
Trading safe-haven currencies is a matter of timing. While they will spike in times of market shock, they also move pretty quickly once the dust has settled. For investors, holding cash or low-interest bonds is expensive, as money can get a better return elsewhere.
Safe-haven currency indicators to watch
If you’re sending or receiving any safe-haven currencies, keep an eye out for good news headlines. The more regularly they appear, the more rotation into risk-on assets and away from the US dollar will occur. Note information on central bank movements. If the US Federal Reserve announces a big package of monetary stimulus such as quantitative easing, that will likely place downward pressure on the US dollar, as interest rates fall to zero or even below, making it a less desirable investment.
The US 10-year bond market is also a good barometer. It is the market’s gauge of inflation, and the higher it rises, the more likely there is to be a hike in official interest rates. Stock markets hate the idea of interest rates rising, so fear of it occurring can result in sharp selloffs - such as the famous “taper tantrum”7 of 2013 when then Fed Chairman spooked the market that QE was coming to an end. The USD shot up as emerging market currencies dropped.8
At the time of writing the US 10-yr yield is at a one-year high9, and currency watchers are keeping a close eye on where it goes next. Whether you are trading the USD or other emerging market currencies, you should too.
Download the OFX Currency Outlook
Learn more in the latest edition of the OFX Currency Outlook. It's been produced to help you navigate market movements today, and to understand what to watch out for in the coming months.