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Continuing the FX series...

We're done with the havens/low betas and ready to move on from the 'uniqueness' of the Euro... πŸ‘‡

FX: The Euro’s Just... Special
Is the Euro a funding currency or a pro-cyclical currency? And why it isn’t truly considered a safe haven...

Time to get some risk on...

(For the International Audience: Naaaaaa = Now in Proper English)

And that's the key word.


Cyclical currencies are highly sensitive to the global economic cycle and tend to rise in value as global economic activity expands (and fall when it contracts). Β 

An economic cycle looks something like this:

A new economic cycle begins as central banks and governments respond to the recession/slowdown (top right).

At this point, confidence is returning and risk appetite starts to pick up.

e.g. Companies invest in new equipment (CapEx), overall consumption increases, aggregate demand improves.

Especially when interest rates are low.

With low interest rates, companies can borrow cheaply to invest, upgrade and generally increase productivity.

Commodities are needed to make the new stuff, so as economic activity picks up, commodity-linked currencies benefit.

Let's take a look at a few of those currencies.

The Canadian Dollar (CAD)

The Canadian economy is heavily linked to oil and oil-related products.


As you'd expect, the price of oil and the CAD are highly correlated πŸ‘‡

CADUSD vs Brent Oil

It's a similar story for...

The Norwegian Krone (NOK)


And a decent correlation to the oil price too...

NOKUSD vs Brent Oil

Moving on from oil currencies, we'll head down under...

The Australian Dollar (AUD)

The Australian economy is heavily tied to the mining and industrial sector.

China is Australia's largest trading partner, and Chinese commodity demand drove Australian economic growth throughout the 2010s...


Iron ore is the largest export (and China the biggest buyer).
The AUD is also sensitive to the copper price...

AUDUSD vs Copper (green) & Iron Ore (orange)

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The Great British Pound (GBP)

The UK isn't known for it's commodity exports, nor is it a commodity currency, so what are the drivers and why is it procyclical...?

For a few years, it was all about Brexit.

Political shocks and public spats led to wild swings in the value of the pound.

Some even argued GBP should be considered an Emerging Market currency on the back of the volatility...

Things have settled down since the UK left in 2020.

So what's the driver now?

Sounds REALLY basic, but here goes anyway... πŸ‘‡

Broad Risk Sentiment

That's it.

And this isn't just true for the pound.

Although there can be large differences between outcomes for the individual economies/currencies, there is one factor that all cyclical currencies have in common.

Especially since 2008.

This 2018/2020 Harvard paper found that in a post-GFC, low interest rate world, currency values are far more influenced by risk sentiment than they were before...

The researchers took the S&P 500 as the benchmark for 'risk premium' and found a strong relationship with cyclical currencies... πŸ‘‡

Focusing on the ten most traded currencies of developed countries, we document that the covariance of exchange rates with equity returns has increased substantially.
For each currency, we estimate yearly rolling regressions of its daily appreciation on the contemporaneous return on the S&P 500 index, a proxy for changes in risk premia, and find that while the conditional beta estimates are noisy and close to zero before the financial crisis, they have become persistently different from zero afterwards.
For instance, the average conditional beta of the Japanese yen and the Australian dollar vis-Γ -vis the US dollar are -0.24 and 0.35 respectively since 2008, but were indistinguishable from zero before.

(Conditional beta is basically correlation dressed up in economic paper lingo)

Due to persistent central bank intervention, cross-currency interest rates aren't the differentiator they once were.

Take a look at the table below... πŸ‘‡

Great, soooo, what does this show?

We order currencies left to right (and top to bottom) on the basis of the average conditional beta for its exchange rate basket, from the most risky (Australian dollar, with a beta of 0.21) to the most safe (Japanese yen, with a beta of -0.38).
Since we use log appreciations, the beta between the Australian dollar and Japanese yen exchange rate and the return on the market must be equal to the difference in their baskets’ with the return on the market, i.e. the beta for this pair is 0.59.

A strong correlation between AUDJPY & the S&P 500?

Who knew?!

Why Does AUDJPY Rise & Fall With Stock Indices?
These two markets ARE correlated, and it’s not because of fair value models or the Big Mac Index πŸ‘‡

Back to the paper (and GBP)

...the degree to which the exchange rate between any two currencies covaries with the return on the market depends on their relative position on the risk spectrum.
The British pound, when measured against the G10 basket, shows no covariation with risky assets, though its beta when measured against the Australian dollar, or the Japanese yen, are -0.21 and 0.38 respectively.
Whilst the rank ordering of conditional betas remains largely fixed throughout the post-2008 sample, two exceptions to this rule are worth accounting for.
The Euro became risky (vis-Γ -vis s the US dollar) during the sovereign debt crisis of 2010, and returned to being safe at the crisis’ resolution in 2015.
The British pound switched from being a safe currency to the riskiest in the sample during the lead-up to the Brexit vote, and then returned to being safe once the uncertainty around the vote was resolved.
In both of these cases, the risks which were driving the currencies were also significant global risk factors in themselves.

What's the conclusion?

Risk sentiment is a key factor for cyclical currencies

Whilst these currencies can increase or decrease their sensitivity to the US equity markets (and broad risk sentiment) due to non-'normal' factors, the overall correlation to 'Risk' is likely to persist while interest rates remain low.

Next in the series, the Wild West world of the highest betas!

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