25 May 2024

The FX playbook: who wins in a pandemic?

| The European |

Currency broker XM casts an eye over the global forex market and reveals that so far it’s reacting to the coronavirus crisis almost as expected

Once upon a time, the currency market used to be driven by interest rate differentials, changes in growth dynamics between countries, government policies, and in some cases by commodity prices. But the world has changed dramatically over the past few months, and so has the FX playbook.

Today, currency moves are mostly a reflection of risk sentiment, and economic data is worth next to nothing as the gloom is overpowered by unprecedented stimulus and liquidity. Emergency interest rate cuts and huge fiscal stimulus packages that would typically harm a nation’s currency, now might lift it. And suddenly, how effectively a country has handled the health crisis itself matters.

At XM, our Investment Research Department have crunched the numbers to reveal which currencies, to date, have performed best and worst during the pandemic, and why.

Defensive currencies win: yen, dollar, and the Swiss franc

It was only natural for the safe-haven currencies to shine the most, as investors sought shelter from the devastating impact of the lockdowns and the impending global recession. Japan is the world’s biggest creditor nation, so in times of market turmoil, Japanese investors tend to cut their exposure to foreign assets and repatriate funds, turbo-charging the yen.

The dollar is a more peculiar case. It doesn’t always behave like a defensive currency, it really depends on the situation and the stage of the business cycle. Think of it as an “all weather” currency; it can appreciate both during boom periods as capital gravitates to the world’s largest economy and during recessions as anxious investors flock to the safety of the reserve asset.

True to form, the greenback roared higher once the crisis began to unfold, despite the Federal Reserve’s best efforts to weaken it. Admittedly, when the world economy falls off a cliff, all investors and corporates want to hold is the dollar – it is liquid, stable, and accepted everywhere.

The Swiss franc is a similar story to the yen. Switzerland enjoys huge current account surpluses, so capital tends to come back in times of economic stress, and this time was no different. And yet, the franc’s gains were much smaller compared to the yen’s. One might deduce that investors view Japan as a safer destination, but that would be a fallacy as the underperformance arises mainly from the Swiss National Bank’s regular interventions in the FX market to prevent the franc from appreciating excessively.

Euro, commodity-linked currencies, and emerging markets suffer

In the G10 FX sphere, the main losers have been the Canadian, Australian, and New Zealand dollars. Commodity exports are the lifeblood of these economies – oil for Canada, metals for Australia, dairy products for New Zealand – so the ensuing collapse in commodity prices and the dim prospects for global growth naturally dragged these currencies down.

Yet, the Australian and New Zealand dollars have recovered a good chunk of their losses. While part of that is likely owed to the improvement in risk sentiment, it might also be a reflection of how effectively these countries handled the medical crisis. Infection rates in both nations are now close to zero, which allows them to re-open their economies sooner and with little risk of second waves of infection.

The euro suffered as well, as worries around the eurozone’s weak institutional infrastructure came back to haunt the single currency. The stimulus measures on a European level have left investors deeply disappointed, both by being too slow and too small. Worst of all, while European leaders agree on the need for massive stimulus, they can’t agree on how to pay for it.

Highly indebted nations, such as Italy, want everyone to share the burden by creating Eurobonds, while creditor states like Germany oppose the entire notion. The bottom line is that ravaged economies like Italy and Spain are unlikely to get the massive fiscal stimulus they desperately need, setting the stage for an anaemic recovery.

And finally, an honourable mention for emerging markets (EM) economies with high external financing needs, whose currencies have borne the most pain. The prime examples are the Brazilian real, the Turkish lira, the South African rand, and the Mexican peso, all of which plunged to new record lows. Many emerging economies rely on commodity exports, run large current account deficits, and some have a lot of debt denominated in US dollars that becomes more expensive to service as the greenback soars – a toxic cocktail in times of crisis.

Predictable enough 
All told, we believe the currency market has so far behaved somewhat predictably in this crisis, unlike its equity cousin that seems disconnected from economic reality thanks to gargantuan stimulus measures. Defensive currencies performed the best while EM currencies suffered the most, which is exactly what one would expect in a global recession.

It remains to be seen whether all these moves have further to go as the crisis deepens, or whether the worst is behind us and a retracement is in order.

Further information


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