The Irresistible Force That Dominates Currency Markets Is Back

Are Currency Wars a Bad Thing for the Market?
  • Emerging-market currencies most tied to stocks since 2013
  • HSBC says it’s becoming harder for investors to stand out

The global currency market is no longer its own master.

Rather than being led by economic data or monetary policy, emerging-market exchange rates are the most closely tied to moves in stocks and commodities since at least 2013. When they fall, it’s almost certain the yen will rise, and vice versa.

The pattern known among traders as risk-on, risk-off is back.

At its most forceful, it can blindly cleave financial markets in two -- categorizing everything from the dollar to the dong as either a haven or a “risk asset” and dictating how they move in response to news or events, regardless of the fundamentals. It’s dogging markets again -- just as it did in the wake of the 2008 financial crisis -- as investors come to terms with the distorting effects of central banks’ quantitative easing.

That means getting the big picture right can take precedence over local insight -- which HSBC Holdings Plc says makes it harder for skillful money managers to distinguish themselves.

“We are going from a QE world to a risk-on, risk-off world,” said David Bloom, London-based head of global currency strategy at Europe’s biggest bank. “At the moment, it feels like a risk-off environment.”

Fed Factor

The recent peak in many of the correlations between currencies and other assets came earlier this year after a stocks rout wiped $9 trillion from global equities.

Now the links are increasing again as investors prepare for a multitude of challenges, from next month’s U.K. referendum on European Union membership and Federal Reserve meeting to the U.S. election in November. The re-emergence of a binary market may already be hurting investors, with currency funds failing to turn a profit in 2016.

Risk-on, risk-off is only likely to get stronger as the Fed gets closer to raising interest rates. When the minutes of the central bank’s most recent meeting were published this week, speculation officials will act sooner rather than later hurt emerging-market currencies and stocks. The yen weakened Friday as equities and commodities rallied.

“There’s a frighteningly fine line between higher U.S. rates being a healthy sign that the economy can cope with Fed policy normalization and their being a trigger for yet another round of risk aversion, particularly in emerging markets,” said Kit Juckes, a London-based strategist at Societe Generale SA. That may cause “the traditional rush of money into the yen as it seeks a safe haven,” he said.

Increasing Ties

The 120-day correlation between an index of 20 emerging-market currencies and a global stocks gauge is at 0.6, close to its level on April 8, which was the highest since December 2013, data compiled by Bloomberg show.

Since a reading of 1 would mean the two were in lockstep, the figure shows that, more often than not, the currencies are moving in line with equities. That’s significant because investors tend to view stocks as a higher risk than assets such as government bonds.

The link with commodities climbed to an almost six-year high of 0.7 this month. In late 2014, neither asset had a significant correlation with emerging-market currencies.

‘In Vogue’

“There’s no doubt about it: that whole risk-on, risk-off game is one that is back in vogue,” said Chris Scicluna, London-based head of economic research at Daiwa Capital Markets Europe Ltd., who also analyzes currencies at the unit of Japan’s second-largest brokerage. “We saw that even in the first quarter when we had that heightened risk-off period.”

The correlation between the dollar-yen rate and stocks reached 0.7 in February, the most since Bloomberg began collating the data in 1987, and is at 0.5 now. That means Japan’s currency tends to weaken as equities rally.

Scicluna cautioned that monetary stimulus remains important. Though the Fed has started raising rates, the Bank of Japan and European Central Bank are still adding to their unprecedented QE.

“I wouldn’t assume that central banks are finished,” he said.

Risk-on, risk-off grew in importance as a driver of foreign exchange in the immediate aftermath of the financial crisis as investors became hypersensitive to market shocks. Monetary stimulus largely wiped it out as an influence by supporting higher-risk equities and safer government bonds alike.

Changing Times

A currency’s relationship with risk can change. The euro’s inverse link with equities peaked at 0.5 at the end of January as it took on a role as a safe place to park money.

The single currency traditionally moved in line with stocks, particularly during the euro-zone debt crisis that started in 2009 -- and briefly reverted to that old relationship last year when the ECB started its stimulus program.

“Within Group-of-10 currencies, you can definitely feel the absence of central banks,” said Eimear Daly, a strategist in London at Standard Chartered Plc, which gets more than half its revenue from developing nations and recommends buying the Mexican peso as commodities rise. “We can definitely see how important the oil price is for emerging-market currencies.”

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