Traditionally, bonds have played a protective role in multi-asset portfolios and often acted as a safe haven during an equity selloff. However, given the low starting point of interest rates combined with the lack of policy space for central banks to cut interest rates further, we believe the potential return from bonds during equity market turmoil is more limited now.
In the search for other defensive assets, could defensive currencies play a role? The answer is yes, in our view, but they should be considered as part of a multi-pronged solution. We know interest-rate differentials are the primary driver of foreign-exchange moves, so the lower bound on interest rates – and thus on spreads – will affect currency markets as well as bonds.
From the turn of the century, we’ve seen two clear periods of compression in short-term interest rates across developed economies. This can be seen in the chart below, which shows the average difference in short-term interest rates across the G10 currencies, some of the most commonly traded currency markets. The financial crisis caused this average differential to halve from roughly 2% to 1%, while the pandemic has caused a further halving to roughly 0.5%.
As can be seen above, periods of equity market stress are usually accompanied by a compression of interest rates. This combination weakens the appeal of the carry trade, which involves borrowing in currencies with low interest rates to buy higher-yielding assets, causing investors to look to exit this popular strategy. As a result, the short currencies (those with lower interest rates) see a surge in demand, causing strength in concurrence with equity market weakness. For this reason, it is the currencies that are usually used as the short legs of this strategy that typically exhibit defensive behaviour.
With spreads smaller nowadays, the carry trade has been less popular, lowering the potential for defensive currencies to shine. We have already seen this happening.
The chart below shows the sensitivity of the euro/Swiss franc exchange rate in periods of equity market stress and demonstrates how this has changed over time. Positive values indicate that when equities sell off significantly, the Swiss franc tends to strengthen relative to the euro.
Importantly, the absolute level of participation has been declining over time, meaning the amount of franc appreciation relative to the size of the equity selloff has been declining. In other words, the defensive nature of the franc has been diminishing. The Swiss franc is not alone in exhibiting this behaviour; this effect is also observable in the Japanese yen, for example.
Do tight spreads also imply interest rates stop being a key driver of currency moves? To test this assertion, we run multiple regressions of exchange rates on a number of well known macro variables – such as interest rates, global sentiment, current accounts, and terms of trade – and average the results across 45 currency pairs.
In the chart below, we can see that two-year rate differentials used to be the most powerful variable to explain currency variability, but have been overtaken by longer-end rates and our proxy for risk appetite (which is a global equity index divided by a global bond index).
This is not too surprising given short-end rates are directly targeted by central banks and policy rates are all close to zero. Our proxy for risk appetite currently explains close to 40% of currency variability, in particular for the historically more volatile commodity currencies (e.g. the Australian dollar and Norwegian krone).
Our takeaway from this is that whilst not having been the number-one influence recently, interest rates – in second and third place – should still be considered an important driver for currency markets. As such, the effective lower bound for interest rates affects currency markets as well as bond markets.
With global yields on the rise this year, accompanied by spreads widening, perceived safe-haven currencies have underperformed, offering little protection in the equity wobbles we have witnessed.
The wobbles have admittedly been small, but we do believe that in the event of a more serious equity selloff the Pavlovian response to buy former safe-haven currencies will still result in outperformance, while in the meantime the carry cost of holding typically defensive currencies is lower.
The lower bound on interest rates nevertheless limits the scope for further compression in interest-rate differentials between countries and regions, in our view. In turn, this limits the potential for past safe-haven currencies to perform during equity selloffs. What were once defensive currency pairs are perhaps no longer a panacea for equity risk mitigation, but will still likely prove to be potent tail-risk hedges, in our view. In order to recreate the diversifying benefits of sovereign bonds, we think we need to consider them as part of a combination of defensive strategies.