Small haven currencies risk policy backlash; AUD, CAD, NOK, SEK on precipice
The increasing attractiveness of the currencies of smaller AAA-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 the fiscal problems in the world’s large developed economies, and the eurozone in particular, have targeted the bonds of the narrowing group of AAA-rated countries, putting upward pressure on the AUD, NOK, SEK and CAD. 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.
Reserve accumulation by active reserve managers
|Source: EcoWin, CitiFX
In the past, such reserve accumulation would have prompted reserve managers to diversify their stockpiles by selling incoming dollars and buying euros.
Clearly, 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.
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, who told a conference in Sydney on Tuesday that as a consequence of the debt problems in Europe, sizeable flows were occurring into Australian government debt.
Australian capital flows
|Source: ABS, RBA
During the first three quarters of 2011, net purchases of Australian government debt by foreigners amounted to more than 3% of GDP, markedly higher than the current account deficit. That pattern of capital flows was likely to have continued in the fourth quarter, Debelle added.
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 now held by foreigners.
“Our discussions with market participants suggest that a sizeable share of recent purchases has been by sovereign asset managers,” said Debelle.
He noted that the portfolio shift was having an effect on the AUD, 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 discomfort.
It is likely that the 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 NOK at it policy meeting on Thursday.
Meanwhile, analysts say that an expected 25 basis point rate cut from Sweden’s central bank is unlikely to stem demand for the SEK given the haven status of the country’s paper.
SEK a safe haven within AAA club - 10 year yields
|Source: EcoWin, ING
Adam Cole, head of FX strategy at RBC Capital Markets, says the Bank of Canada is less likely to push against strength in the CAD, although notes it has verbally intervened against weakness in the US dollar in the past.
Steve Barrow, analyst at Standard Bank, says the problem, of course, is that if investors are sucked into the smaller AAA markets, like 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 relative to the size of the FX market as well.
“If the trend towards fewer AAA countries continues, we still see a risk that the likes of the Aussie, Canadian dollar, Swedish krona and Norwegian krone could be pushed to levels that become deeply uncomfortable for policymakers,” he says.
“There is clearly a risk that if investors are sucked into these AAA markets, any reversal, however temporary, could hit bonds – and the currency – hard.”