Non-core currencies offer safe haven from Eurozone woes

The crisis in the Eurozone has created volatility for the continent’s primary currency, but a number of other currencies in Europe have benefited from investor demand for safe havens. The question now is whether this currency play has run its course

A safe bet: investors are seeking exposure to non-core currencies

In the developed world, post-crisis fears have driven many investors to opt for what they perceive as safe havens, notably US Treasuries and German Bunds. This was not simply a flight to quality, as it was sometimes labelled; rather it was liquidity that many investors were seeking. To that end, only established and deep sovereign bond markets like the US, Germany and the UK could provide the kind of liquidity investors wanted. While none of these countries could offer either enviable public debt figures or encouraging debt-to-GDP dynamics, they were at least relatively easy markets to get out of.

Yet by the end of 2010 liquidity was not enough, especially in the Eurozone, where investment risk began to seep in from Europe’s troubled periphery towards the currency zone’s stronger core and put the currency itself under the spotlight. Faced with this risk, investors looked at alternative ways to tap into any growth that was happening in Europe. Certain non-core currencies offered a means for them to do that.

“We have some investment strategies within Europe for non-core currencies, especially in the Nordic region where there was an interest rate hike from the Riksbank [Sweden’s central bank] in mid-February [from 1.25% to 1.5%], which was quite positive for the currency as well because Sweden has a better economic outlook,” says Laurent Crosnier, chief investment officer of Amundi’s London office. “Raising rates is good for the currency, and offers a way for us to provide diversification across different economic cycles.”

Crosnier goes on to explain that Amundi was long these non-core currencies against the euro because at one stage the euro was “a little bit overvalued”.

The non-core story has attracted investors across Europe, even those in the core euro area countries such as Germany. For investors with a portfolio mandate limited to Europe but spooked by Eurozone troubles, the region’s ‘other periphery’ became a natural focus. It also appealed to those convinced Europe would resolve its problems and achieve economic growth, but who wanted to sit out the medium-term volatility in the single currency zone, or at least be hedged against it.

“Non-core currencies are definitely a success story, especially if you look at the development of non-euro currencies,” says Dirk Aufderheide, Frankfurt-based head of currency at DWS Investments, Deutsche Bank’s asset management operation. “The Scandinavian currencies, the Swiss franc and, in recent weeks, sterling have all performed well. That was definitely due to a shift towards interest rate differentials rather than a risk-off correlation building up. Risk-off trades do not work as well as they did in the past. But it was not only the Swiss, Norwegian and UK currencies; it was also commodity currencies like the Canadian and Australian dollars.”

Within Europe, the Norwegian and Swedish currencies have demonstrated particular strength over the past year. The Swedish krona was valued at 0.09717 versus the euro on January 1, 2010, but climbed steadily to reach 0.11286 on March 14, 2011. The Norwegian krone, meanwhile, rose more modestly from 0.1211 against the euro at the start of 2010 to 0.1277 on March 14 this year. Recent form has seen it often trade above that level, hitting a peak of 0.1299 on March 2, 2011.

Swiss roll

There are two clear motivations driving investor focus on Europe’s non-core currencies: value and safety. While the euro would have still been viewed as a safe haven currency in 2009, the sovereign debt crises in Greece and Ireland in 2010 undermined that status, while the interest rate independence of ex-Eurozone countries drew investors towards them instead. Although fear still stalked markets, it was the search for a safe haven that furrowed investor brows more than anything else. According to Aufderheide, it still does.

“Without question, Europe’s safe haven currency is the Swiss franc,” he says. “It has recently been called ‘the European gold’. The Swiss franc has appreciated versus the dollar and the euro, and the rise in global interest rates and yields appears to have worked in its favour. There is Eurozone peripheral risk and budget risk in the US. The Swissie is definitely the safest currency haven out there.”

The Swiss franc proved its worth during the turbulence of 2008, appreciating 14.18% from the start of that year to 0.6902 versus the euro by October 28. Its status has not changed since that period, either, with investor enthusiasm towards it improving further in recent months. Indeed, recent enthusiasm may even have left the Swiss franc slightly overvalued, given its rise from 0.6729 versus the euro on January 1, 2010 to 0.7733 on March 14, 2011. However, so long as Europe’s dominant currency is not out of the woods, the Swiss franc should continue to benefit.

“If you are very much afraid of something going horribly wrong in Europe – and March is an important month with a lot of European meetings [most importantly the leaders summit of March 24–25, where short-term and longer-term crisis resolution mechanisms were discussed] – then it makes sense to invest in some other liquid currencies. The US dollar and Swiss franc make best sense,” says Jaco Rouw, senior foreign exchange strategist at ING Investment Management in The Hague.

“Last year valuations in Europe were attractive for the Swiss franc, and the economy was clearly outperforming relative to Europe [Swiss GDP grew 2.9% in 2010, according to the International Monetary Fund, compared with an average of 1.8% for the euro area]. The Swiss franc has gone from undervalued to overvalued. The currency should be lower against the euro, but the possibility of things going wrong in Europe is another reason to be bullish on the Swiss franc,” he adds.

Although the Swiss franc is the most liquid of the European safe haven plays, it is not the only non-core European currency offering protection from Eurozone risk. Moreover, some of the alternatives may not yet have all their value priced in.

“We are long the Norwegian krone,” says Arif Husain, head of European fixed income at AllianceBernstein in London. “We do not feel strongly on the Swiss franc, which does not trade as a macroeconomic play but as a safe haven, although it is relatively unpredictable and buffeted by flows. Norway and especially Sweden sometimes get used as carry currencies but they are also fundamentally very strong. Besides, both countries have active central banks so inflation is not a major risk.”

At the emerging, eastern end of Europe, some investors see value in the Polish zloty and Turkish lira, although Turkey’s bond yields have suffered following oil price pressure stemming from the Libyan crisis. The Turkish lira was at 0.45476 versus the euro on March 14, significantly down from its 2010 high of 0.52472 (May 18), but close to where it opened 2010 (0.46506). The Polish zloty, on the other hand, lost almost a third of its value against the euro between July 2008 and February 2009, and has since been tracking slowly upwards again. It was at 4.0368 versus the euro on March 14.

“There is value in the Turkish lira because it declined sharply against the euro, but the country is so close to the geopolitical risk area [the Middle East] that any deterioration of the situation would definitely be a problem for the lira,” says DWS’s Aufderheide. “If you are convinced Saudi Arabia will not be affected too much, then the Turkish lira has some definite potential. Beyond that, the Polish zloty is interesting, as it is close to the Eurozone. Poland is battling high unemployment as well as inflation, but the central bank is on track in terms of fighting inflation. Poland’s currency looks to be the closest to the core European currencies for the medium term.”

Show your appreciation

Non-core currencies have already enjoyed significant inflows in recent months. Thus, while these currencies may have a more positive outlook versus the euro, investment opportunities have narrowed alongside spreads. Although certain investors see appreciation potential in sterling versus the euro, elsewhere continued gains look to be muted. The Canadian dollar, for example, rose from 0.8195 versus the dollar on January 1, 2009, to 1.0252 on March 14. Over the same period, the Australian dollar, another ‘commodity currency’, rose from 0.7054 to 1.0078.

“Currencies like the Swedish krona, the Swiss franc and the Norwegian krone have enjoyed positive appreciation, as have commodity currencies like Canadian and Aussie dollars, but their extra value is definitely priced in now,” says Aufderheide.

Moreover, investors are looking to different themes to drive their currency allocations. Whereas in 2010, public debt dynamics and commodity prices remained paramount, oil prices are now the main driver of sentiment.

“Commodity currencies were mainly a 2009 and 2010 story, a bit like what we have seen for Sweden and Norway,” says Roux at ING. “In 2008, those countries all became undervalued and commodity prices plunged but Australia, New Zealand and Brazil have become quite overvalued, so I cannot see these currencies as safe havens. The key driver at the moment is oil prices.”

The oil price factor is forcing a wedge between currencies that might otherwise trade at similar levels, such as the Norwegian krone and the Swedish krona, since Norway is an oil exporter while Sweden is a net importer.

“One trade we like is long Canada and Norway versus short Australia, on the basis of whether they are oil exporters or importers,” says Roux. “If oil prices really spiralled out of control and you got some kind of shock to risk sentiment, then the Australian dollar would become one of the weaker currencies. A risk-off environment would support that kind of allocation too. It is broader themes [such as oil prices] that are providing the main momentum in currencies, rather than individual country growth stories.”

Rates redux

Another key differentiator between currencies in 2011 will be the timing of interest rate increases across developed markets. There is little consensus among central banks in terms of the urgency to ‘normalise’ rates, while inflation figures also vary across markets. As the importance of rate outlooks and sentiment increases, so the relative impact of each currency jurisdiction’s macro fundamentals (versus other factors) on the currency itself can only subside.

Differentiation in rates and policy is growing within developed markets as some central banks have stepped in to cool price growth already. Australian interest rates are at 4.75%, last moved in November 2010, when they were raised by 0.25%. It was the seventh increase in rates by the Reserve Bank of Australia since October 2009. Norway’s policy rate is also higher than many developed market peers, at 2%, with its last hike (by 0.25%) carried out in May 2010.

Sweden has increased its benchmark repo rate five times since July 2010, most recently by 25bp in February to 1.5%. With its economy relatively booming compared with other developed countries – growing at 4.4% in 2010 according to the IMF – further rate hikes are expected this year. Canada’s rate may be lower at 1%, but its central bank did raise rates by 0.25% last September.

Central banks in some other developed economies, however, have been unwilling to move rates upwards while the economic recovery in those countries remains fragile. The UK benchmark rate sits at 0.5%: the Bank of England’s last rate change was a downward move (of 0.5%) in March 2009. The Swiss central bank last moved rates in March 2008, when it lowered them from 0.5% to the current 0.25% (highlighting that the Swiss currency play is more a function of liquidity than positive rates momentum). Japan has held rates at 0% since October 2010; and even before that they were only at 0.1%.

However, with inflation a growing concern, rate increases are back on the policy agenda. “Rate rises will be an important theme this year, whereas over the last few years they have not been that important,” says Aufderheide. “Most countries were cutting rates to rock bottom, but this year you will see monetary policy differentiation become an important driver of currencies once again. If you look at the correlations between exchange rates and short-term rates, you can see they have gone up in recent weeks.”

The most important cleavage in policy is expected to show itself in the European Central Bank raising rates faster and more aggressively than the US Federal Reserve. The ECB currently has interest rates at 1%, against a Federal Reserve rate of 0.25%, but many in the market anticipate an April move by the ECB.

Part of this difference of approach between the developed world’s two most important central banks is down to the Fed’s wider mandate, since it is supposed to set rates to aid growth as well as to hold inflation steady, whereas the ECB is only supposed to target inflation. Any move by the ECB is likely to be followed by Europe’s other central banks.

“The central bank of Norway indicated a few weeks ago that rate increases by the ECB would make it easier for it to hike rates,” says Aufderheide. “Once the ECB hikes, it will become easier for Sweden, Norway, Switzerland and the UK to follow suit.”

However, the ECB’s relative eagerness in increasing rates could be harmful to the currency’s prospects, according to George Goncalves, head of rates strategy at Nomura in New York. If Goncalves is right, then the non-core currency rate hikes expected to follow on the heels of any ECB rise would also be hasty, putting growth – and value – at risk.

“You have the March madness in Europe just now with all these key meetings,” says Goncalves. “These goings-on mean Treasuries are outperforming European government bonds. Add the fact that the ECB is being more hawkish: if it scares its own market, then Europe will underperform against the US, which is not going to raise rates any time soon. The market is getting worried about the ECB.”

Keeping an eye on growth

Given the market traction already gained by Europe’s non-core currencies, some investors might be tempted to head for the apparent security of the core once again. Nevertheless, according to Ralph Sherman, head of emerging markets and Scandinavian rates trading at RBC Capital Markets in London, the macro fundamentals of the non-core economies still mark them out as natural investor focuses in the months ahead.

“The Swedish economy is the opposite of almost any economy in Europe at the moment except Germany because it is absolutely motoring ahead,” says Sherman. “The central bank has been hiking rates at every single meeting. Norway is moving more slowly but clearly these are completely different from other economies in the Eurozone. Swedish rates should probably be 3% or 4%.

“The good thing about Norway is that it has such a big oil market and little debt, so it does not have all the problems of the Eurozone countries and the UK and US. In this environment that is the biggest advantage you can have. As the European situation gets worse, holding Norwegian and Swedish assets makes even more sense,” he adds.

First among those assets are the countries’ currencies, which allow their governments and central banks to manage their domestic growth trajectory more independently. But with Europe’s non-core currencies already enjoying a period of favour, currency diversification in Europe still makes sense. For some investors, European currencies generally offer significantly better growth potential than the US dollar. Aufderheide expects that fund flows out of emerging markets would naturally head to Europe rather than the US.

“I am very, very cautious on the US because of the budget requirements, so I would suggest avoiding the dollar or underweighting it in strategic terms,” he says. “In Europe, however, you have a nice opportunity to diversify your portfolio towards the Norwegian, Swiss, UK and Swedish currencies. You might add some commodity currencies like Canadian dollars, although the Australian dollar is suffering from high oil prices, so I would underweight that as well as the yen, which clearly has no potential for a couple of years.” [These comments were made before the mid-March earthquake disaster in Japan.]

Aufderheide views the dollar as banking on its role as a source of liquidity rather than quality. But where he is bullish on Europe overcoming its difficulties, in part due to support from external creditors such as China, and on the euro developing a larger role as a reserve currency, others see the US dollar as about to change course. If that argument holds good, it would make it a good time for currency investors to cross the Atlantic.

“The dollar is nearing the bottom,” says Goncalves at Nomura. “Similar to the Treasury story, if the US recovery is not taken off track, then the dollar will strengthen and the US will stop quantitative easing, allowing the situation to normalise. The dollar should not be this weak and the flight to quality will eventually come back to it.”

That may not bode well for Europe’s non-core haven currencies. “The dollar is better-priced versus these currencies, and we think it is better versus the commodity currencies too because a lot of their potential is priced in,” says Goncalves. “They have done well and enjoyed flight-to-quality status but they are now too highly leveraged to commodities. There are many reasons to be positive on the dollar, but the two most important are: one, it is cheap and, two, it is mispriced if you think a recovery is under way.”