“Investors unwinding the carry trade seek liquidity as much as safety,” said Chris Walker, G10 FX Strategist at UBS. “The liquidity premium associated with the Scandinavian currencies leads to capital flight during periods of risk aversion, as investors seek more liquid assets.”
Of the G10 currencies the Swedish krona and Norwegian krone have this year had the highest levels of volatility relative to the Dow Jones Industrial Average, with the exception of the Australian dollar.
A key benchmark for beta in most currencies is interest rates but the Scandinavian currencies have exceptionally high betas relative to their nominal interest rates, suggesting liquidity is a material concern for investors, UBS argues.
However, it is important to bear in mind that trading volumes of krona and krone are small relative to other G10 currencies, with the lowest market share of worldwide daily turnover outside of the New Zealand dollar.
The problem is exacerbated by low debt levels and a lack of liquid investible assets, Walker said. Swedish bond issuance is forecast to be the lowest this year since 1977.
In the most recent Riksbank Risk Survey, some 52% of participants said liquidity was the biggest concern for the Swedish financial system. The problem is worse at times when investors are heavily committed to the currency, Walker said.
“The risk of volatility is greater when people are heavily long the Scandis, with investors moving into the euro currency,” he said.
While taking long volatility positions on Scandinavian currencies has been a winning strategy, investors should be aware that medium-term positioning is likely to mitigate the liquidity effect, with the long Scandi trade not as crowded as it once was.
In addition, diversification strategies promised by Norway’s sovereign wealth fund, and reduced reliance on oil, will reduce exposure to Europe and reduce eurozone-related volatility.
“Volatility may be overpriced in both krona and krone,” Walker said. “We see potential for convergence with other carry-trade pairs.”
| Chart: yield not the driver for NOK, SEK |
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| Source: Bloomberg, UBS FX Strategy |