“Risk tolerance” remains the “driving factor” in currency markets, says Neil Mellor of Bank of New York Mellon. Just look at the last few days. Last week, the euro fell marginally against the dollar and lost 4% against the yen. Sterling tumbled by almost 5% against both. The dollar in turn lost almost 4% against the yen on the week. Equities also slid.
By Monday 8 December, a recovery in risk appetite (helped by news of Barack Obama’s spending plans) gave stockmarkets worldwide a fillip and put downward pressure on the ‘safe-haven’ currencies, the yen and the dollar. Bloomberg notes that, over the past month, 90% of the time the yen has moved in the opposite direction to the pan-European DJ Stoxx 600 index.
So why is the yen rising? Its strong gains – up 27% against the euro in the last three months – are thanks to the unwinding of carry trades, whereby investors borrowed in low-yielding currencies, especially yen, sold them and bought higher-yielding ones or other risky assets. Unwinding these trades means buying back the funding currency, which is boosted by the higher demand.
The dollar also funded carry trades and benefits from the traditional safe-haven appeal of US government bonds. Miserable data outside America, such as the 6.1% slump in German manufacturing orders in October alone, reinforce this trend. So even the nastiest slump in payrolls since 1974 did nothing to dent the dollar last week as it underpinned global risk aversion, says Mellor.
With the world economy on track for the worst downturn since the war, the risk-aversion theme is hardly likely to be over yet. The yen is the “default beneficiary” of all this, says Alan Ruskin of RBS Greenwich Capital. On the carry trade front, many foreign investors have unwound their trades. But there is still a long way to go in this regard for Japanese investors, whose holdings of foreign assets, notably bonds, jumped from ¥10trn to ¥50trn between 2000 and 2008, says Merrill Lynch. The fact that other central banks are now slashing rates is also good news for the yen, as it means that the yield differential with other currencies is closing.
The trend away from riskier and higher-yielding assets as carry trades unwind suggests there’s more weakness ahead for the Australian and New Zealand dollars, two favourite carry-trade destinations. The fact that rates are tumbling and the economies rapidly weakening in both countries (in Australia the central bank has cut rates by 3% in three months, while New Zealand is in recession) is reinforcing the trend. Westpac sees the New Zealand dollar, now over $0.50, sliding to $0.45 in the first quarter of 2009.
Meanwhile, the overall exodus from emerging markets and the sharp slowdown in central Europe portends more trouble for the Polish zloty and the Hungarian forint, which Merrill’s Benoit Anne thinks could fall by another 9% and 14% against the euro respectively.
As for sterling, it has already shed around almost 30% against the dollar from its peak. At just below $1.50 it remains above the $1.37 low point it hit after falling out of the European Exchange Rate Mechanism in 1992. An International Monetary Fund analysis suggests that the pound, having been “ridiculously overvalued” at $2.10, is now slightly undervalued against the greenback, with fair value around $1.53, says John Authers in the FT. But foreign exchange rates typically overshoot on the way up and the way down. So it could easily fall below $1.37 amid further bad news on the housing front – our housing bubble was even bigger than America’s – and a vanishing yield differential as “central banks converge upon zero”.