It isn’t just equities: there have been plenty of extreme moves in the forex markets over the past few days too. Last week, for instance, the yen gained 20% against the Australian and New Zealand dollar respectively; by early this week it had appreciated by around 15% against the euro in two months, reaching a three-year high. The Korean won hit a decade low against the greenback; Iceland’s krona touched a record low against the euro; and the dollar reached a five-year high against the pound.
The overall trend, which has seen the yen and the dollar strengthen, the euro and the pound weaken and emerging-market currencies sell off, is mounting risk aversion. The global turmoil has prompted the unwinding of carry trades, whereby investors borrowed in low-yielding currencies, notably the yen, and changed the money into high-yielding currencies, such as the South African rand or the Australian dollar, or bought other risky assets. As these trades are unwound, the yen has to be bought back. That has sent it soaring.
The dollar has also benefited from the global flight to safety. Global jitters tend to prompt buying of US Treasuries – bonds denominated in the world’s reserve currency are seen as a key safe haven, and the trend has been accentuated as poor data have spread across the world from America. Investors are “not sure where else to go”, as Harvard’s Kenneth Rogoff told the International Herald Tribune. Moreover, financial institutions across the world have borrowed in dollars, so there has been a scramble for dollar liquidity globally as struggling banks have sought to meet dollar funding requirements amid scarcer credit.
Early this week risk aversion receded as more concerted global action to rescue the financial system bolstered spirits. The euro gained 2% against the dollar on Monday, for example, and high-yield currencies, such as the Aussie dollar, recovered. But the trends highlighted above are unlikely to be over just yet.
While the latest global moves may prevent a total financial meltdown, we are still “heading into a global recession”, as former IMF chief economist Simon Johnson says. That’s bad news for emerging Asia, where the Singapore economy, deemed a leading indicator for the trade-dependent region, is now contracting.
Eastern Europe looks particularly vulnerable, given the region’s large current-account deficits; some countries face a “painful” contraction as investors “flee countries with large external funding needs”, says Marcus Walker in The Wall Street Journal. As “the reality of global recession sinks in”, further losses for emerging-market currencies are on the cards, says Robert Beange of JPMorgan. There is “substantially more downside” for emerging currencies, agrees Morgan Stanley’s Stephen Jen, which have hardly priced in the global recession scenario.
A “brave new world” of diminished risk appetite and unwinding carry trades, along with Japan’s relatively robust economy, the likelihood of further rate cuts outside Japan and the yen’s historic cheapness, implies further gains for the Japanese currency, says Capital Economics. It is pencilling in another 10% rise in the yen against the dollar by the end of 2009, while it expects Britain’s ailing and imbalanced economy to keep sterling under pressure and falling another 7%, drop to $1.60 by mid-2009. And the euro? Given rising risk aversion amid a global recession, you’re better off with the dollar, reckons Jen: $1.20- $1.25 is a “reasonable” range in the next year (the rate is now around $1.35).