It used to be relatively straightforward. At times of risk aversion, investors flocked to the dollar, along with the Swiss franc and yen. The euro barely got a look in.
However, in recent months the euro has started to show signs of correlation with risk aversion, while the dollar has gone the other way. This has left some managers wondering where to turn in times of market stress.
A breakdown in the correlations between currencies and risk assets is making life difficult for investors, says Sandra Crowl, member of the investment committee at Carmignac Gestion, the French independent asset manager with €53 billion in assets under management.
“In 2014, we have seen the dollar display a negative correlation with risk assets like the S&P at around -0.4, making it a very good safe haven at the start of 2014, before changing to a positive 0.2 correlation in the summer of 2015,” says Crowl.
Part of the reason for the breakdown of formerly quite reliable correlations might be the emergence of the euro as one of the world’s leading funding currencies.
Greg Anderson, global head of FX strategy at BMO Capital Markets, believes “the euro has taken over from the dollar as the global funding currency of choice, the dollar having taken over from yen before that”.
The rationale for this is relatively clear. From a systematic point of view, and based purely on one-month interest-rate differentials, the euro ranks third among the best G10 currencies to fund carry positions, behind the Swiss franc and the Swedish krona.
A systematic, diversified and short-term carry strategy is therefore likely to have a moderate short position in euros, but is likely to have a greater weighting in the two other currencies.
However, from a discretionary perspective, many traders give a higher weighting to their euro shorts. Talk of more quantitative easing in Europe has fed expectations of further euro weakness, while its greater liquidity might be attractive, especially for larger positions.
|QE has led to increased extreme positioning|
|Source: Chart #1: JPMorgan, European Client Survey; Chart #2: CFTC; Chart #3: Citi Research|
Despite offering negative interest, the Swiss franc’s strong appeal as a safe haven means it is liable to strengthen, while the krona is a relatively illiquid currency.
The chances are the argument for funding with euros is only going to get stronger in coming months.
James Wood Collins, CEO at Record Currency Management, says: “If the Fed does raise rates in December and if other countries such as the UK also tighten, the relative yield curve may start to favour using the euro even more as a funding currency, even for systematic strategies.”
One counterintuitive result of this is that the euro has started to display the characteristics of a risk-off trade. A crisis in the market encourages investors to unwind their short positions, buying back euros and causing it to appreciate against other currencies.
Conversely, if the US dollar, as rates rise, becomes more of an investment currency – and some already view it as such – it could theoretically become a risk-on trade.
There has been some evidence of this. On August 24, the panic surrounding China had seen equity futures in New York make their maximum permitted daily declines, leaving traders looking for proxies. This contributed to a USD sell-off against the euro and yen.
While dollar weakness against the yen has been seen before in times of heightened stress, given the yen has long been seen as a safe haven, it is unusual for it to weaken against the euro.
BMO’s Anderson says the euro’s tendency to appreciate in moments of heightened risk aversion is a new phenomenon.
“The result of the carry unwind will make it look and behave like a safe haven,” he says. “In the past the US has borne that burden, as we saw in 2008 when, despite being at the epicentre of the crisis, it appreciated around 15% against other currencies.
“Now there is more of a shared safe-haven burden involving EUR, USD, JPY and CHF.”
Carmignac’s Crowl suggests a European Central Bank (ECB) rate cut might trigger some profit taking, though given traders would not be forced to act by hitting their stop losses, it would be a relatively gentle bounce.
When it comes to traders looking for safe havens, Crowl believes investors are now making their choice according to where they perceive the risk from which they are seeking sanctuary.
“If a risk-off environment is caused by a negative event in Europe, the disinvestment from real investors is likely to offset the unwinding of speculative positions and the euro should stay flat or weaken, as it did during the Greek crisis around the referendum date,” says Crowl.
“But if the cause is outside Europe, as it was with China in August, there is no disinvestment to offset the unwinding of positions, and the euro is more likely to strengthen.”
Neil Staines, head of trading at ECU Group, agrees, but only to a point. “The knee-jerk reaction will depend on the source of the risk, but after that it is more about the global response,” he says.
And while Crowl worries about the breakdown in correlations between risk and currencies, Staines argues such dislocations were more of an aberration than a permanent shift in behaviour. “The dollar’s historic correlation to market risk appetite isn’t quite back to normal, but it is heading that way,” he says. “Risk-off means a rising dollar, against everything but maybe yen.”
Certainly the funding environment for euros looks to have shifted again. Short positioning has eased from its most extreme levels in the summer, with positioning in Chicago futures reaching their most extreme levels around July, before the Chinese equity crash cleared the market out in August. Today euro short positioning in Chicago futures is only two-thirds of that peak level.
“Risk-off won’t drive a rise in euros now the way it did when we saw the Dow move 1,000 basis points in a day, partly because there is more conviction now around the Fed’s December hike and partly because of expectations around ECB easing,” says Staines.
“There is much less uncertainty around monetary policy trajectories, and thus funding, now.”
Even Crowl agrees that, while it is difficult managing risk on a day-to-day level, if things get really ugly, investors will do as they have always done.
“Ultimately, if there was a really major crisis, USD is still where we would want to be,” she says.