The world’s most promising risk-on currencies are changing

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Currency analysts warn that the Australian dollar might no longer be the monarch of risk-on currencies, writes Institutional Investor, a sister publication of EuromoneyFXNews.

The Australian dollar has, during the past half decade of financial turbulence, earned its spurs as the queen of risk-on currencies — plunging 37% in little more than three months as the credit crunch hit financial markets in 2008, only to regain virtually all the lost ground by the close of 2009 as the initial panic about the global economy subsided.

However, even the most glorious of reigns must come to an end, and currency analysts warn it might be the aussie’s turn to pass the crown to a new monarch.

The Australian dollar has been seen by institutional investors as, in particular, a China play — a way of gaining exposure to growth in the world’s second-largest economy without having to dabble in the opaque and half-closed world of Chinese equities. Australia’s strength in the production of industrial metals, such as zinc, has created a correlation between the aussie and Chinese economic growth, since that growth has been generated largely through massive, metal-hungry investment in infrastructure projects.

However, analysts warn that attempts by the Chinese government to create a better balance in the economy, by shifting away from investment and towards consumption, could hit the Australian dollar by changing the nature of China’s commodity requirements. This would move it away from industrial commodities and towards those resources for which the Middle Kingdom’s surging middle class has a growing appetite.

The obvious winner among currencies, at first sight at least, is the New Zealand dollar. Three quarters of its resource exports are farm commodities, including dairy products, which are benefiting from the change in China and much of the rest of Asia from oriental to more expensive western tastes. However, the kiwi’s prospects are made murky by the dark shadow of the country’s larger neighbour. Australia buys almost one quarter of its goods exports, creating a natural positive correlation between the two currencies, which has been strengthened by currency arbitrage trades.

Even the most ingenious arbitrage trader will find it hard to discern any stable relationship between the price action of the aussie and that of the krona circulating in the far distant Kingdom of Sweden. The Swedish krona is a common vehicle for risk-on trades based on optimism about global growth because the country’s stock market is dominated by multinationals, such as the telecoms equipment maker Ericsson, whose revenue comes overwhelmingly from overseas.

However, Sweden has its own powerful, potentially baleful neighbour: the eurozone. The OECD forecast on Tuesday that the currency union’s economy would shrink in 2013 for the second straight year.

There are, however, two risk-on currencies whose countries sandwich a powerful neighbour with a potentially benign influence: the Canadian dollar and Mexican peso. The US dollar’s historical status as a safe-haven currency has made it an asset ill-fitted to bullish bets on the country whose economy it serves.

However, Canada’s extremely strong reliance on the US market – destination for about three-quarters of its exported goods – counter-intuitively makes this foreign currency more suitable. It also has another ace in its pocket: as a net oil exporter, it stands to benefit not just if growth in the US is strong, but also if economic activity rebounds across the world.

The Canadian dollar has recently been a more reliable risk-on play than either the aussie or the kiwi, according to HSBC’s Risk-On/Risk-Off index, which measures the correlations of individual assets with risk-on assets as a whole.

Given Mexico’s large net exports of petroleum, the Mexican peso would also gain from increases in global oil demand generated by worldwide economic growth. Moreover, should global growth disappoint, the peso is moving into a progressively stronger position to survive the disappointment – analysts think it might suffer more limited damage than in previous global downturns.

"Mexico will be a standout performer in the region, given the process of key economic reforms – labour, fiscal and energy – that will improve the medium- and long-term outlook for the economy," say Morgan Stanley currency strategists in a recent note. "On the back of these reforms, together with improvements in manufacturing competitiveness, we expect the Mexican peso to outperform into 2014."

Moreover, Mexico’s dependence on the US for its export sales is as extreme as Canada’s — making it a good vehicle for US bulls. The peso appreciated steadily from June to September on renewed optimism about the US economy. At 12.9 to the dollar in Friday trading, it remained stronger than its late May level of 14.4.

"Poor Mexico, so far from God and so close to the United States," the Mexican dictator Porfirio Díaz once lamented. In the coming months, however, this proximity might work in the peso’s favour — making it a promising receptacle for global growth hopes in general and for rosier US prospects in particular.