Global Macro Strategy MORGAN STANLEY & CO. INTERNATIONAL PLC+Sheena Shah
STRATEGIST
What Is the Best Safe-
Haven
Currency?
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John Kalamaras
STRATEGIST
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om
+44 20 7677-6457
+44 20 7677-2969
We expect the US dollar (USD) to be the best safe-haven
MORGAN STANLEY MUFG SECURITIES CO., LTD.+
Koichi Sugisaki
STRATEGIST
August 18, 2020 04:00 AM GMT
currency, especially now that lower US rates make it a more
@
m
Shoki Omori
+81 3 6836-8428
attractive funding currency for carry trades. JPY and CHF @ +81 3 6836-5466
remain safe havens, but their dynamics are shifting.
We are often asked whether CHF and JPY are still safe-haven
currencies. We say yes they are, but suggest that USD is likely to
become the favored safe haven as the fall in US rates this year makes it
an attractive funding currency for borrowing and carry trades.
Recent correlation and flows analysis suggests that USD/JPY could even
rally in times of risk-off, counter to market perception. We find that
Japanese investors have actually bought foreign assets in times of risk
uncertainty and didn't repatriate.
CHF should remain a safe-haven currency, but its appreciation
potential is limited by Swiss National Bank FX intervention.
We analyze the characteristics of a good safe-haven currency in detail
in this article and conclude that USD would be the best currency to
buy in risk-off.
Buying USD versus AUD screens as the strongest risk-off hedge in G10.
JPY should strengthen versus AUD, NZD, NOK or GBP in times of risk-
off, but we think that JPY should be stable or even weaken versus USD, as
USD becomes the better risk-off hedge.
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What is the best safe-haven currency?
We are often asked whether CHF and JPY are still safe-haven currencies. We say yes they are, but
suggest that USD is likely to become the favored safe haven as the fall in US rates this year
makes it an attractive funding currency for borrowing and carry trades. Recent correlation and
flows analysis suggests that USD/JPY could even rally in times of risk-off, counter to market
perception. CHF should remain a safe-haven currency, but its appreciation potential is limited by
Swiss National Bank FX intervention. We analyze the characteristics of a good safe-haven
currency in detail in this article.
What are the characteristics of a safe-haven currency?
- Appreciates when risk assets weaken.
- Used as a funding currency to sell for FX carry trades and for international corporate
borrowing, so is typically low-yielding.
- Perceived to be a safe-haven currency so is bought by speculators as a hedge or in times of
stress.
- Often the country has large net international investment holdings (FX-unhedged) which
have the potential to be repatriated in times of stress.
Do you need a current account surplus? No – the US dollar has a deficit and is a safe haven as
it is used as a funding currency.
Exhibit 1: Summary statistics on what makes a good safe-haven currency
3m correlation
S&P 500 Oil
3m borrowing rate
Latest 2020 chg.
Perceived to be
safe haven
Daily FX volume
(USDtrn)
Net IIP
(% GDP)
FX positioning
(futures, % OI)
✓
?
-56
-1
✓ 69
✓ -17
✓ 107
41
-40
-58
✓
✓
✓
✓ 249
USD
EUR
JPY
GBP
CHF
CAD
AUD
NZD
NOK
SEK
?
16
Safe haven characteristic IIP: international investment position; OI: open interest
Opposite of safe haven characteristic
Source: Macrobond, Morgan Stanley Research
What are the best risk hedges in G10?
Based on all the detailed analysis below, we conclude that USD would be the best currency to
buy in risk-off. Buying USD versus AUD screens as the strongest risk-off hedge. Buying CHF
versus USD or EUR doesn't screen well as the SNB is intervening in FX markets to stop CHF
strength. JPY should strengthen versus AUD, NZD, NOK or GBP in times of risk-off, but we
think that JPY should be stable or even weaken versus USD, as USD becomes the better risk-off
hedge.
Trade idea: Remain long EUR/CHF via selling 6m EUR/CHF ATM puts (~
strike, receiving %, priced and entered on July 17, 2020).
Our current view is that risk sentiment should remain supported, so we keep a bearish skew on
USD and are short CHF versus EUR.
CHF/JPY is a popular cross to consider the relative effectiveness of safe-haven currencies. Exhibit
2 Shows that CHF/JPY has been strengthening since May, when EUR/USD started rallying. Risk
sentiment has been strong throughout the period so it could also be suggested that JPY is more
of a safe-haven currency than CHF, in line with the conclusion from other sections in this report.
So, while it may be tempting from a technical perspective to say that CHF/JPY should now
weaken from the top end of the channel, we wouldn't suggest doing that unless, against our
view, risk markets start to weaken.
Exhibit 2: CHF/JPY is now trading at the top end of a multi-year channel
Source: Bloomberg, Morgan Stanley Research
What do the statistics say? Which currency has been a safe haven?
We start by investigating the day-to-day trading behavior of USD, CHF and JPY crosses, focusing
purely on market variables. For each currency, we calculate the three-month daily correlation
of each CCY/G10 cross with a 'risk barometer' and then track the average of those currency cross
correlations across time. This allows us to not just focus on one or two important crosses for
each currency, but rather consider all the possible G10 combinations and the way they usually
trade.
Exhibit 3: CHF and JPY have historically traded as safe havens, with an average negative correlation to risk
sentiment
Source: Bloomberg, Morgan Stanley Research
We use the S&P 500 as a representative global risk barometer for the analysis below, given that
the S&P is currently the most representative proxy for equity market risk sentiment and the
recent strong correlation of FX with equities. Repeating the analysis with a number of alternative
risk proxies – including Morgan Stanley's Global Risk Demand Index (US Pat. No. 7,617,143), US
10y real yields and the MS Financial Conditions index – yields similar results (see Exhibit 5).
Exhibit 4: Correlations with risk appetite are
similar regardless of whether JPY or CHF is the
funding currency
Source: Bloomberg, Morgan Stanley Research
Exhibit 5: Results are similar regardless of which
risk proxy we use
Safe
havens?
Source: Bloomberg, Morgan Stanley Research; Note: FCI is financial conditions index.
JPY and CHF have indeed been exhibiting a relatively stable negative correlation with risk across
the different G10 crosses since the 2007-08 financial crisis, although JPY’s correlation has tended
to be stronger (more negative) than that of CHF (see Exhibit 3). This can be partly attributed to
the long-lasting, very accommodative monetary policy in Japan (BoJ QQE), which has created a
relative abundance of JPY liquidity relative to CHF.
USD results have been more mixed over the years, but we note that USD's correlation with risk
has been getting more and more negative since March 2020, as the Fed cutting rates to the zero
lower bound has made USD a more attractive funding currency for borrowing and carry trades.
Running a PCA analysis confirms that the broader USD trend has become an increasingly stronger
driver of USD/CCY pairs as of late (see Exhibit 6), all while USD's positive correlation with risk
is diminishing. USD's increased safe-haven nature seems to be mostly at the expense of JPY, as CHF
average correlation has continued getting more and more negative (see Exhibit 7).
Average 3m CCY/G10 cross correlation with variable
S&P 500 US 10y real GRDI MS FCI Gold
NOK
NZD
AUD
CAD
GBP
SEK
EUR
USD
JPY
CHF
Exhibit 6: Contribution factor of PC1 (broader USD
trend) has increased recently
Exhibit 7: USD correlation with risk has turned
negative at the expense of JPY
Source: Bloomberg, Morgan Stanley
Research Source: Bloomberg, Morgan Stanley Research
In terms of the different crosses, all crosses except CHF/JPY currently have a negative
correlation with the S&P (see Exhibit 4). Correlations tend to be similar regardless of whether
CHF or JPY is used as the funding currency, with the correlation against risk- sensitive currencies
(AUD, CAD, NOK, NZD) being significantly negative. SEK is a notable exception, but this is
likely because SEK has not been acting as a risk-sensitive currency across all crosses as of late.
Looking at individual currency drivers again confirms CHF and JPY's safe-haven trading nature.
We run one-year regressions of CHF/EUR and JPY/USD to try to identify the main drivers for
each currency. CHF is naturally negatively correlated with all moves that signal risk-on –
stronger equities, higher yields and a steeper curve (see Exhibit 8). The same is true for JPY, with
the sensitivity of USD/JPY to US rates in particular being relatively high, likely a function of
the USD leg and the recent moves seen in the US rates space (see Exhibit 9).
Exhibit 8: CHF negatively correlated to higher
equity and yields, steeper curves
Exhibit 9: JPY's negative correlation to US rates is high
Source: Bloomberg, Morgan Stanley Research
Source: Bloomberg, Morgan Stanley Research
Exhibit 10 shows the performance of each G10 currency versus USD during downturns in the US
equity market. USD, JPY and CHF appreciate on average, while AUD, CAD, NZD,
SEK and GBP depreciate on average. All major equity downturns since 1998 Saw AUD, NZD, CAD,
NOK and SEK depreciate versus USD, while GBP depreciated in all downturns since 2000.
Exhibit 10: USD, JPY and CHF appreciate during S&P 500 bear markets
Peak date
S&P 500
Trough date Change
CCY/USD performance over the period
DXY EUR GBP JPY CHF SEK NOK AUD NZD CAD
% % % % % % % % % %Average
Median % % % % % % % % % %
11-Jan-73 03-Oct-74 -48% -7% N/A -1% 1% 28% 7% 20% 2% 8% 1%
21-Sep-76 06-Mar-78 -19% -10% 10% 13% 22% 32% -6% 2% -8% 4% -13%
28-Nov-80 12-Aug-82 -27% 35% -30% -28% -18% -19% -30% -26% -16% -24% -6%
25-Aug-87 04-Dec-87 -34% -8% 9% 11% 8% 10% 6% 4% -2% 6% 1%
16-Jul-90 11-Oct-90 -20% -8% 7% 10% 14% 10% 6% 7% 4% 4% 1%
17-Jul-98 31-Aug-98 -19% 0% 2% 2% 0% 5% -1% -4% -9% -6% -5%
24-Mar-00 09-Oct-02 -49% 2% 1% -2% -13% 10% -8% 13% -10% -2% -8%
09-Oct-07 09-Mar-09 -57% 13% -10% -32% 18% 2% -29% -23% -29% -35% -24%
29-Apr-11
20-Sep-18
19-Feb-20
03-Oct-11
24-Dec-18
23-Mar-20
-19%
-19%
-34%
9%
3%
3%
-10%
-3%
0%
-7%
-4%
-11%
6%
2%
0%
-5%
-3%
0%
-12%
-3%
-4%
-11%
-7%
-18%
-12%
-3%
-13%
-6%
1%
-10%
-10%
-5%
-9%
Source: Bloomberg, Morgan Stanley Research
The funding currency = the safe haven
We think that the most important factor determining whether the currency appreciates in times
of risk-off is whether it was used as the funding currency for carry trades in times of risk-on.
There are a variety of forms of carry trades, but the one monitored the most is that done by
speculative FX investors. FX investors sell a low-yield currency, which they borrow, to buy a
higher-yielding currency to receive the interest. In times of uncertainty, those carry trades may
be unwound, resulting in appreciation of the currency that was borrowed, the funding currency.
It should also be considered whether a currency is borrowed by corporates to invest (often
from the debt markets) and if borrowed by investors to buy assets such as equities. This is
why some currencies depreciate when equity markets rally.
In summary, USD is becoming a more attractive funding currency today so is more likely to
exhibit safe-haven behavior in times of risk-off.
Exhibit 11: USD rates have fallen fast this year,
becoming attractive versus EUR rates
Exhibit 12: USD is the dominant funding currency
for global borrowing
Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research
What drives a funding currency choice? The cost of borrowing is the largest driver, followed by
availability of the currency in the market (is that banking sector large?) and if the currency is
likely to stay stable or weaken in the future. We've written more about this topic in What's the
Funding Currency of Choice?
As the Fed cuts rates aggressively this year, the US dollar has become a more attractive funding
currency. At the start of 2020, EUR was used as a funding currency for EM FX carry trades and
corporate borrowing, but now USD is likely to take its place. The EUR/USD rally in early
March 2020 was due to the unwind of short EUR/EM carry trades.
Exhibit 13: Many currencies have low rates now across the G10 and EM
Source: Macrobond, Morgan Stanley Research
Which bank has been lending abroad? Liquidity and availability of the currency are also
important in choosing a funding currency. For example, PLN has a low monetary policy rate at
% but global investors are less likely to borrow PLN to fund carry trades as Poland's banking
sector is smaller than say the eurozone, so is less likely to lend in large size, and also PLN is at risk
of selling off and trading like the broader EM bloc in times of uncertainty.
Based on the liquidity and availability of currencies, we expect USD, EUR, JPY and CHF to remain
the largest global funding currencies but that USD's share as a funding currency will be much
larger than the others.
Exhibit 14: USD and EUR banks were lending
abroad at a faster rate recently, while JPY banks
weren't
Exhibit 15: USD remains the dominant global
funding currency
Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research
What about other currencies? Exhibit 13 shows that there are many currencies where their
central banks have cut rates to close to zero. Does that mean they could be alternative funding
currencies too? We use data on corporate borrowing in their non- local currency to guide us on
the changing dynamics on funding currencies and find that US corporates have opted to borrow
more in their local currency – USD – this year rather than continuing to borrow in EUR. The
falling USD rates and the Fed buying corporate debt have supported the shift. We wrote more
about the dynamic recently in Is The Euro Still Used As A Funding Currency?
Exhibit 16: USD remains the dominant funding
currency for corporates
Exhibit 17: US corporates have opted to borrow
in USD locally recently instead of EUR
USDbn YTD YoY Corporate issuance by currency (2020)
500
450
400
350
300
250
200
150
Global corporate debt issuance in currency
that is not the local currency (USDbn) USD
EUR
150%
100%
50%
0%
%
%
%
100
50
-50% %
%
0
00 02 04 06 08 10 12 14 16 18
USD EUR JPY SEK CHF AUD
-100%
%
USD EUR JPY NOK SEK GBP CAD CHF AUD
Foreign Domestic
Source: Bloomberg, Morgan Stanley
Research
Source: Bloomberg, Morgan Stanley Research
Could AUD or CAD become funding currencies? The RBA and BoC have both cut rates to close
to zero this year (25bp), the lowest level ever. FX carry trades where a G10 currency like USD,
EUR or JPY was sold for a higher-yielding emerging market currency have historically been
popular. This year, as EM central banks have also cut rates, the carry adjusted for the level of
currency volatility and growth risk has diminished for many EM currencies.
.7%2
%%
If the markets want to express a view that EM growth will do better but are worried about the
fluctuations of the US dollar, then an alternative could be to short AUD or CAD to buy EM FX.
AUD and CAD have both historically been highly correlated to EM currencies, so could start to
become popular funding currencies. We don't think that the market has this position currently.
Exhibit 18: Both CAD and AUD have had high and
similar correlation to EM/USD
Exhibit 19: AUD, SEK, CAD, NOK and NZD have
recently been correlated with EM FX
Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research
FX liquidity and availability
Low rates are attractive for a funding currency but the availability of the currency to borrow in
large amounts is also important. A bank's willingness to lend mostly depends on central bank
monetary policy and bank regulation. In the past year, the central bank asset purchases, liquidity
injections and rate cuts have pushed broad money supply to grow the fastest for USD, with M2
rising by 22% versus a year ago. Relative to the typical growth of broad money supply, JPY has
also seen a faster growth rate, being towards the right side of Exhibit 20. Growing money supply
makes it easier for these currencies to be used for funding carry trades. Additionally, USD, EUR
and JPY are three most traded currencies in the FX market each day (see Exhibit 21).
Exhibit 20: USD and JPY broad money supply have
grown the most in the G10 in the past year
Exhibit 21: USD is the most widely traded
currency every day, followed by EUR
Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research
Heavy carry trade FX positioning matters for safe-haven
performance
Following the performance of FX carry trades may also guide us in determining whether the
short positioning in the funding currency is starting to build and possibly getting extreme. For
example, in February 2020, short EUR/EM became a consensus short as the carry trade was
working. However, increasing market volatility due to COVID-19 caused those carry trades to be
unwound quickly, leading to a EUR/USD rally of over 6%.
FX carry trades have also not performed well this year. A G10 FX carry trade index (see Exhibit
22) fell 12% peak-to-trough this year and is now around 7% lower compared to mid-February.
The index tracks the cumulative return of going long the three highest- yielding G10 currencies
and short the three lowest-yielding ones with an equal weight.
Exhibit 22: G10 carry trades have not performed
well this year
Exhibit 23: G10 FX market positioning isn't long carry
Source: Bloomberg, Morgan Stanley Research
Source: Bloomberg, Morgan Stanley Research
The underperformance of carry trades was mostly a function of the elevated FX market
volatility in March, with USD appreciating significantly versus the rest of the G10 at a time
when the Fed aggressively cut rates to zero, moving USD from one of the highest- yielding G10
currencies to one of the lowest. Carry trade performance recovered as risk appetite normalized,
although the recent strength of EUR, JPY and CHF have also weighed on the index’s performance
since mid-July.
FX positioning via futures contracts suggests that the market is generally long the lowest-
yielding currencies (CHF, EUR, JPY) but is also small long the highest-yielding G10 currency, AUD
(see Exhibit 23). The recent short USD momentum versus EUR does not appear to reveal a strong
directional positioning in long or short carry trades.
Going forward, should the carry trades do better, then the funding currencies listed above should
weaken. The difficulty today is that the carry differential between the G10 currencies is so small
that there are few carry trades left. CHF stands out as having very low and negative cost, but
short EUR/USD is no longer an attractive carry trade. USD can thus start to take over as a
funding currency for speculative FX carry trades.
What's drives JPY to be a safe-haven currency?
A safe-haven currency is one that tends to be favored during risk-off phases. As noted above,
funding currencies are perhaps most likely to meet this definition owing to the tendency for
various positions to be unwound in reaction to some sort of risk-off event.
The basic requirements for funding currency status are (1) an expectation that funding costs will
remain low for the foreseeable future and (2) adequate liquidity as well as ability to be used for
settlement purposes. (1) will generally be viewed as an incentive to put on carry trades, while (2)
should help to instill confidence in exchangeability for various products during times of crisis.
CHF and JPY are good examples of currencies satisfying (1), while the US dollar clearly satisfies
(2).
Exhibit 24: The BoJ has kept the policy rate at a
low level over the past two decades relative to other
central banks
Exhibit 25: JPY has had large turnover among
major currencies
FX daily average turnover (USD trn)
2001 2004 2007 2010 2013 2016 2019
Source: Haver Analytics, Morgan Stanley Research
USD EUR JPY GBP AUD CHF CAD CNY
Source: BIS, Morgan Stanley Research; Note: Turnover data include FX derivative
trades as well.
USD
EUR
JPY
JPY is a funding currency: The BoJ's policy rate has been at or near zero for most of the past two
decades, with Japan's protracted struggle against deflation allowing for just two rate hikes in
2006. Market participants have thus become accustomed to Japan having a particularly low
policy rate by G10 standards (see Exhibit 24), making it quite understandable that they (a) feel
confident that the yen will remain cheap to borrow and (b) use borrowed yen funds to buy
overseas assets in the hope of generating better returns than are offered within Japan. On top of
this, the yen itself is also one of the world's most traded currencies (see Exhibit 25), making
liquidity more than satisfactory. The basic criteria for funding currency status have thus clearly
been met.
Japan's sizeable external creditor positions tend to make repatriation a market theme during
risk-off phases: As discussed in Understanding Investors in Japan, Japan's government has
repeatedly relied on expanding the fiscal deficit as it looks to stimulate the economy out of its
protracted slump (see Exhibit 26). The flipside has been continued growth in private sector
savings, which ultimately leaves Japanese financial institutions with more funds to invest.
A substantial proportion of these funds has been channeled overseas in search of better carry
and better capital gain prospects, with Japan becoming and remaining the world's biggest external
creditor as a result (see Exhibit 27). The yen's perceived status as a safe-haven currency has
seemingly owed much to the conventional wisdom that an overseas recession is liable to trigger a
surge in repatriation by Japanese investors, entailing massive conversions of USD and other foreign
currencies back into JPY.
Exhibit 26: Private sector savings have increased
as the government has expanded the fiscal deficit
Exhibit 27: Japan has the largest net
international investment position in the
world
Source: Haver Analytics, Morgan Stanley Research Source: Haver Analytics, Morgan Stanley Research
The reality is actually different: The reality does not actually support this conventional wisdom,
however, with historical data offering no evidence of Japan's outward direct and portfolio
investment being withdrawn (repatriated) during risk-off phases (see Exhibit 28). As discussed in
Keep Risk Hedges On, the Japanese investors that have been building up foreign asset positions are
predominantly non-depository financial institutions, such as pension funds, life insurers and
investment trusts (see Exhibit 29).
Exhibit 28: Japan has maintained capital exports
even under the risk-off regime
Exhibit 29: Non-depositary financial institutions
mainly have accumulated foreign asset exposure
Source: BoJ, Morgan Stanley Research Source: BoJ, Morgan Stanley Research
Life insurers and pension funds generally look to the (very) long term, which basically only leaves
investment trusts as investors that are sensitive to mark-to-market fluctuations: Looking at what
has happened following the September 2008 Lehman shock and other major risk-off events of
the past, we find that the aforementioned Japanese investor categories have actually tended to
add to their foreign asset positions rather than cutting back as the repatriation theory might
dictate (see Exhibit 30).
Exhibit 30: Japanese real money investors would
rather have accumulated foreign assets in the event
of a risk-off move
Exhibit 31: USD/JPY has traded rich relative to
the level where US-Japan real yield differentials
have suggested
Source: Bloomberg, Morgan Stanley Research
Source: Japan Mof, BoJ, Morgan Stanley Research
This pattern has been particularly clear over the past years, with the BoJ having launched its
"entirely new dimension of monetary easing" back in 2013 and then adopting its current negative
interest rate policy in 2016. The entire JGB yield curve has been depressed to levels that leave
domestic investors with no option but to seek more lucrative opportunities abroad. Long-term
investors such as pension funds and life insurers have thus tended to view any dips in the yen as
opportunities to buy higher- yielding foreign assets, with this real money demand effectively
serving to keep USD/JPY higher than appears warranted by either US-Japan real interest rate gaps
or the so- called 'shadow rate' differential (see Exhibit 31).
In other words, the tendency for JPY to be bought up during risk-off phases has ultimately owed
less to actual repatriation by Japanese investors than to the behavior of foreign players in
putting on speculative yen-long positions and unwinding carry trades (see Exhibit 32). Of course,
Japanese lifers can reduce their FX hedge exposure via selling FX forwards or buying JPY call
options in the event of a risk-off move, but FX hedge activity has depended more on FX hedge
cost rather than FX level recently (see Exhibit 33).
Exhibit 32: Non-commercial investors tend to be
long JPY in the event of a risk-off move
Exhibit 33: Lifers' USD FX hedge activity tends to be
driven by USD/JPY FX hedge cost
Source: Bloomberg, Morgan Stanley Research Source: Company disclosures, Bloomberg, Morgan Stanley Research
Might JPY relinquish its safe-haven status to USD? It is difficult to envisage the yen surrendering
its safe-haven currency status any time soon, given that it will very likely continue to meet the
criteria for a funding currency, with domestic interest rates almost certain to remain depressed as
the BoJ persists with its "yield curve control" regime. That said, we do see some potential for JPY
to start being viewed in a different light versus USD.
Our main scenario is for USD to keep weakening in the medium term as US real interest rates
continue to fall, with global carry (income) differentials now largely eroded and investors thus
likely to pursue capital gains by using cheap USD funding to buy assets in countries with better
growth prospects. Japan is unlikely to be a direct beneficiary, given that its own growth prospects
appear far from rosy, but the USD/JPY pair may remain quite insensitive to risk-on/risk-off
swings as both currencies continue to be used for funding purposes.
As discussed in Keeping the Faith, US interest rates are currently so low that demand for USD
among Japanese investors is liable to be limited even when the exchange rate reaches ostensibly
attractive levels. Moreover, with the general consensus seemingly pointing to a weakening of the
greenback, we would basically expect Japanese investors to hedge away FX risk for any purchases
of USD assets that they might end up making (with an eye to exploiting cheap USD funding
costs).
USD/JPY might not regain its previous sensitivity to risk until and unless US interest rates move
significantly higher and Japanese investors see sufficient incentive to ramp up their foreign
investment: Our US rates strategists expect US interest rates to start
climbing through the end of this year, which could make USD/JPY at least a little more prone to
fall during risk-off phases and rise when risk appetite is improving. Current conditions look
conducive to USD/JPY falling even during risk-on phases in the short term, but we still see
ample potential for USD/JPY to rally to around 110 as US interest rates rise by the end of 2021.
CHF sensitivity to risk to fall
When considering whether a currency is a safe haven, there are common pairs that are watched.
For CHF it is EUR/CHF rather than USD/CHF, while for JPY it is USD/JPY. This makes the analysis
complicated as we have to consider the counterpart currency too. We consider whether EUR/CHF
is a safe-haven pair, but our analysis is cut short because the Swiss National Bank's FX
interventions (selling CHF) have prevented CHF strengthening to a level which the markets
would have sent it to. This suggests that should the SNB continue its high level of FX
intervention, CHF's sensitivity to risk may fall and so it becomes less effective as a safe-haven
currency.
Repatriation flows less likely to occur or move CHF. Switzerland, like Japan, has a large and rising
foreign asset position. However, an important distinction is that the country’s foreign asset
position has been increasingly dominated by the SNB’s growing FX reserves, a result of increased
currency interventions by the central bank (see Exhibit 34). Such investment is less prone to
repatriation, in our view, as the currency allocation of the SNB’s FX reserves has tended to
remain stable across time and has not been heavily influenced by risk off-episodes (see Exhibit
35).
Exhibit 34: Outflows from Switzerland are mainly
attributed to SNB reserve diversification
Source: Bloomberg, Morgan Stanley Research
Exhibit 35: The SNB's currency allocation has been
stable for years while its balance sheet has kept
growing
Source: Bloomberg, Morgan Stanley Research
Excluding the large flows into foreign assets caused by the SNB’s diversification of FX reserves,
Switzerland’s net foreign asset position has increased only marginally recently, while private
investors have continued to have a very limited international exposure, following the big foreign
asset liquidation in the years after the European debt crisis. In that sense, there are fewer assets for
Swiss investors to bring home in a risk-off environment, thereby reducing any repatriation
support for CHF.
Swiss pension funds have also been continuing to hedge away their FX exposure (see Exhibit 39).
This suggests that even if foreign assets were to be repatriated, the impact on CHF would be
limited. The composition of foreign asset holdings is also important. Excluding SNB reserves,
Switzerland’s second-biggest net accumulation of foreign assets is in debt instruments, both short
term and long term. This poses additional headwinds for any repatriation-driven CHF
appreciation, as fixed income portfolios are more likely to be FX-hedged than equity ones.
Exhibit 36: The majority of Switzerland’s foreign
asset are invested in the eurozone...
Exhibit 37: ...although Switzerland’s exposure
to USD- denominated assets has risen a lot
Source: IMF CPIS, Morgan Stanley Research; Note: Horizontal axis labels represent
countries, not FX. Source: IMF CPIS, Morgan Stanley Research
Is CHF more likely to react to broader risk sentiment rather than any EUR-specific risk? Looking
at Switzerland’s total asset holdings by country shows that most of Switzerland’s foreign asset
exposure is to the eurozone, with more than CHF 600 billion worth of assets invested in
countries of the bloc as of 1H19 (see Exhibit 36). This is partly a result of the country’s close
geographical proximity and deep economic and trade integration with the bloc. The US comes
second, with approximately CHF 330 billion worth of assets invested by Swiss residents.
However, looking at Switzerland’s foreign asset allocation by currency points to a different
picture. Prior to the European debt crisis of 2010, the majority of Swiss foreign assets were
denominated in EUR. This changed in the years following the crisis, with the share of USD-
denominated investment increasing by almost three times to just below CHF 600 billion (see
Exhibit 37). We think that USD asset exposure increased in part due to US equity valuations but
also Switzerland buying debt issued in USD by a variety of countries, possibly from EM (see
Exhibit 38). In contrast, the proportion of EUR- denominated equity and debt assets has barely
increased since the European debt crisis of 2010.
Exhibit 38: Switzerland’s higher USD asset exposure
is due to equity and long-term debt accumulation
Exhibit 39: Swiss pension fund FX hedge ratios are high
70
Swiss pension funds' foreign currency exposure
60
(% of total assets)
FX exposure before hedging
50
40
30
20
10
Source: IMF CPIS, Morgan Stanley
Research
0
06 07 08 09 10 11 12 13 14 15 16 17 18
Source: Complementa, SNB, Morgan Stanley Research
The analysis above suggests that a big European risk-off episode is unlikely to trigger a major
repatriation flow from Swiss investors as their exposure to eurozone assets fell significantly after
2010 and has not recovered since. Even if some limited repatriation flows were to occur, the FX
impact of such a move would be much more limited than it was ten years ago.
On the other hand, eurozone investors could possibly redirect EUR into CHF investments instead
as a risk-off hedge, due to CHF's perceived safe-haven nature. While this remains a possibility,
Switzerland’s very low yields, relatively small equity market size and the SNB’s strong
determination to prevent a sharp EUR/CHF depreciation from taking place should prevent any
such large safe-haven flows from materializing. It can also be argued that the eurozone is in a very
different situation today compared to the past. The EU recovery fund has taken the bloc one step
closer to achieving a stronger fiscal and political union, making it unlikely that CHF will see a
similar magnitude of
safe-haven demand from foreigners.
Rather, the big exposure of Swiss residents to US equity markets means that CHF is more likely
to be impacted by a US-centric or broader risk sentiment move. This hypothesis is confirmed by
looking at empirical data. We estimate one-year regressions of EUR/CHF with different global
and Europe-specific market variables (see Exhibit 40). The latest results suggest that movements
in more global variables like European and US equity markets as well as the Morgan Stanley
Global Risk Demand Index tend to explain a larger proportion of the variance in EUR/CHF
compared to OAT and BTP spreads with Bunds.
Correlation with such global variables is also higher, with the negative correlation of
EUR/CHF with BTP-Bund spreads having fallen to almost zero over the past year (see Exhibit
41). This suggests that, in the absence of fears surrounding the eurozone’s survival re-emerging,
CHF's safe-haven nature is likely to be dictated by global, rather than purely regional, risk
appetite.
FX exposure after hedging
Exhibit 40: Global variables explain a larger
proportion of EUR/CHF’s variance compared to
EUR-specific ones
Exhibit 41: Correlation of EUR/CHF with the
BTP-Bund spread has become less significant
Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research
What about repatriation potential in the rest of the G10?
A common assumption in the market is that safe-haven currencies appreciate in times of risk-off
because the residents in that country repatriate their foreign risk assets. We think that this
dynamic is still applicable but would note that the impact on currency valuations could be very
small if those assets are FX-hedged. Now that interest rates are close to or below zero in most
G10 countries, the cost of FX hedging the foreign asset is much lower than at the start of the
year. This could mean that over time large foreign asset holders would also need to be funding
currencies to have safe-haven characteristics.
Exhibit 42: CHF and JPY have a large
volume of international assets
Exhibit 43: CHF and JPY mostly have
foreign debt exposure
Source: Macrobond, Morgan Stanley Research
Source: Macrobond, Morgan Stanley Research
Exhibit 42 Shows the net international investment position for each G10 country. NOK, CHF,
JPY, CAD and SEK have positive net IIP positions, meaning that residents in those countries own
more foreign assets than non-residents own of assets in those countries.
NOK's large foreign asset position is due to the sovereign fund, which can only own assets in a
foreign currency so would not necessarily repatriate due to risk-off (recent NOK purchases for
fiscal spending came after initial risk-off NOK weakness). CHF and JPY also have large foreign
asset positions of 107% and 67% of GDP, respectively. We need to check the size of the FX-
unhedged foreign asset position to determine whether the currencies could appreciate a lot due
to repatriation of foreign holdings.
In this article we have focused on which currencies appreciate in times of risk-off, but each
currency is part of a pair. Exhibit 43 shows the breakdown of the international asset exposures
into equity, debt and foreign direct investment. NZD, AUD and GBP have large net international
liability positions due to their persistent current account deficits, with a large proportion of the
liability from foreigners owning their debt. NZD, AUD and GBP were also among the weakest
currencies in the G10 during the March 2020 volatility spike, so could form the counterpart to
the safe-haven currency.
Is the euro a safe-haven currency?
Low rates make EUR an attractive funding currency for a carry trade, as was the case at the start
of 2020. Today, as the EUR FX spot rate is appreciating and expectations are set for more
appreciation, it makes EUR a less desirable funding currency despite having lower rates than
USD. The market isn't currently short EUR or particularly long carry currencies (see Exhibit 23),
so we would not expect EUR to appreciate should risk markets weaken.
At the same time, US corporates have been using EUR less for borrowing this year, with a large
proportion of EUR issuance coming from Swiss or UK companies, indicating that EUR's growth
as a funding currency has eased. Less corporate issuance if market volatility picks up should thus
have a limited impact on EUR's valuation, meaning that it is not the best safe-haven currency
right now.
We are not saying that the euro cannot become a safe-haven currency again. If EUR/USD were
to head towards a weakening path, the ECB cuts rates further or eurozone banks push to lend
more abroad, then EUR could become a G10 safe-haven currency.
Exhibit 44: Valuation methodology and risks
Trade Entry Level Entry Date Rationale Risks
Sell 6m EUR/CHF
ATMF
() puts
% 16-Jul-20 We suggest adding long EUR/CHF exposure
as a lower-volatility way of expressing the
bullish eurozone/Europe theme. EUR/CHF
downside is limited by the Swiss National
Bank intervention, which we think will get
more aggressive the more EUR/CHF falls
down towards . The trade benefits from
the still negative skew as investors have
bought CHF as a broader risk hedge.
Peripheral spread widening and a broader
risk-off period, which may occur in August,
although we are confident the SNB will reduce
the upside for CHF
Source: Morgan Stanley Research
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COVERAGE UNIVERSE INVESTMENT BANKING CLIENTS (IBC) OTHER MATERIAL
INVESTMENT SERVICES
CLIENTS (MISC)
STOCK RATING
CATEGORY
COUNT % OF
TOTA
L
COUNT % OF
TOTAL IBC
% OF
RATING
CATEGORY
COUNT % OF
TOTAL
OTHER
MISC
Overweight/Buy 1288 39% 337 45% 26% 573 39%
Equal-weight/Hold 1418 43% 328 44% 23% 678 46%
Not-Rated/Hold 4 0% 1 0% 25% 3 0%
Underweight/Sell 554 17% 86 11% 16% 225 15%
TOTAL 3,264 752 1479
Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment banking
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