Safe Havens: Changing nature of risk, reward, yield, & uncertainty - TDS

Research Team at TDS, suggests that post Brexit, the nature of safe havens has changed and they believe that the basket of currencies (which is limited in its right) that typically attracts inflows in times of market turmoil has shrunk.

Key Quotes

“In particular, we think this applies to the CHF due to the fundamental nature of the Brexit shock; the Swiss economy is highly levered to the UK banking system. This magnifies the risks of financial contagion. Against a backdrop of softening portfolio inflows and an interventionist central bank, the prospect of investing in a negative yielding asset (particularly one that is negative throughout the entire sovereign curve) becomes less attractive from a capital preservation point of view.

While the USD stands to gain from this process, the JPY may benefit disproportionately overall. We think the shrinking basket of ‘safe havens’ will add more downward pressure on USDJPY and heighten the risk of unilateral intervention, although we believe this is unlikely to succeed in the end. Almost without exception, in our view, intervention succeeds only when it is conducted on a multilateral basis. The problem is that there is limited to no support from the much of the G7 bodies to support ‘yentervention’.

This leaves the EUR, which is likely to suffer from both financial and economic contagion risk post-Brexit. Indeed, Brexit is a deflationary growth shock that has the potential to spread beyond its borders to neighboring Eurozone. The economic and financial risks also feed into political risks that could fester ahead of the crucial elections in France, Germany, and the Netherlands next year. That said the impact on the EUR is not clear-cut.

For one thing, German bunds are also quite negative in nominal terms so unless the ECB aggressively cuts the depo rate further into negative territory, the scope for real yields to decline in tandem with falling breakevens is limited. Real yields, in fact, could rise, and that could provide some support to the EUR even as adds to its accommodative stance. For now, we think EURGBP will remain supported, as idiosyncratic risks are more prominent at this juncture in the GBP leg.

We think this landscape opens dollar bloc currencies to a more complicated adjustment process. There will be a much clearer reach for yield and right now within G10 FX the dollar bloc currencies offer both positive real yields and solid credit ratings. This is not necessarily novel but in a world where capital preservation (from NIRP) and low (and potentially lower) for longer rate environments will persist, fixed income managers will increasingly look to FX to generate alpha strategies. This could lead to a steady inflow into these currencies (at the expense of those in the epicenter of the shock), especially as central banks diversify outside of European currencies. This could, after all, soften the blow to these currencies as current account deficits remain elevated and underscore the need for further economic rebalancing.”