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Capital Markets

Foreign exchange: Small haven currencies risk policy backlash

AUD, CAD, NOK, SEK on precipice; Risk of value reversal

The attractiveness of currencies of smaller triple-A-rated countries has raised the prospect of a backlash from policymakers and heightened the chances of a sudden reversal in their value.

Investors looking for a haven from fiscal problems in developed economies have targeted the bonds of the narrowing group of triple-A-rated countries, putting upward pressure on the Australian dollar, Norwegian krone, Swedish krona and the Canadian dollar.

There appears to be room for further appreciation, especially as emerging-market reserve managers begin to see their currency reserves grow for the first time in months.

Indeed, the rise in risk appetite that heralded the start of the year has seen investors push money into developing economies, which in turn has raised emerging-market central banks’ reserves as they attempt to smooth the appreciation pressure on their own currencies.

Citi estimates – based on its gauge of reserve accumulation by active, early reporting reserve managers – that accumulation in January was positive for the first time since October and at its fastest pace since July.

Such reserve accumulation normally would have prompted reserve managers to diversify their stockpiles by selling incoming dollars and buying euros. Given the debt crisis in the eurozone, that trade is no longer so compelling.

"As a consequence, the diversification trade may be disproportionately to buy G10 smalls and emerging-market currencies," says Steve Englander, head of G10 strategy at Citi.

Australian Capital Flows  
Net inflows, adjusted for US dollar swap facility in 2008 and 2009 
Sources: ABS; RBA 

The extent to which the debt crisis has changed the behaviour of reserve managers was highlighted by Guy Debelle, assistant governor of the Reserve Bank of Australia (RBA), who told a conference in Sydney that as a consequence of the debt problems in Europe, big flows were moving into Australian government debt. The RBA estimates that foreign purchases of Australian government debt rose by 40% in the first three quarters of 2011 and that 75% of the total stock is held by foreigners.

"Our discussions with market participants suggest that a sizeable share of recent purchases has been by sovereign asset managers," says Debelle.

He noted that the portfolio shift was having an effect on the Australian dollar, which was close to its record high despite the decline in Australia’s terms of trade since September, as commodity prices pulled back from their highs.

It is not just policymakers in Australia that are voicing concerns. It is likely that Norges Bank, which is hesitant to cut interest rates due to fears over a house-price bubble, will take the opportunity to talk down the krone and might even loosen monetary policy despite the domestic inflationary build-up.

Indeed, the central bank, which has said it is "watching carefully" the appreciation of the krone, appeared to soften its stance on interest rates after the currency hit a nine-year high against the euro on February 17.

Four days later, Øystein Olsen, governor of Norges Bank, warned investors about the risks of moving into the krone. He said if the krone remained at its current level, it would affect monetary policy.

Narrow door

Adam Cole, head of FX strategy at RBC Capital Markets

Adam Cole, at RBC Capital Markets, says the Bank of Canada is less likely to push against strength in the Canadian dollar

"I have repeatedly reminded investors we are not like the Swiss franc," he said, adding that due to the relatively tight liquidity in the krone, the currency might be hard to sell if it suddenly weakened. "I don’t give advice to investors, just remind them the door is narrow." Meanwhile, an expected 25-basis-point rate cut from Sweden’s central bank last month did little to stem demand for the Swedish krona, given the safe-haven status of the country’s paper.

Adam Cole, head of FX strategy at RBC Capital Markets, says the Bank of Canada is less likely to push against strength in the Canadian dollar, although he notes it has verbally intervened against weakness in the US dollar before.

Steve Barrow, analyst at Standard Bank, says the problem is that if investors are sucked into the smaller triple-A markets, such as Australia’s, yields could fall too sharply relative to the domestic economic situation.

He says inflows into bonds could prove quite large, relative not just to the size of the bond market but to the size of the FX market as well.

"If the trend towards fewer triple-A countries continues, we still see a risk that the likes of the Aussie and Canadian dollar, Swedish krona and Norwegian krone could be pushed to levels that become deeply uncomfortable for policymakers," says Barrow.

"There is a risk that if investors are sucked into these triple-A markets, any reversal, however temporary, could hit bonds – and the currency – hard."

This story first appeared on EuromoneyFXNews.

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