Vasileios Gkionakis, Head of FX Strategy, Banque Lombard Odier & Cie SA
In this note, we look at the recent empirical evidence to identify the currencies, including gold, that could most effectively hedge a big risk-off episode in case the virus threat morphs into a global pandemic (not our central scenario) that severely disrupts activity, trade, and value chains for longer than we currently expect. As proxies for risk appetite, we use equity returns and US 10Y yield changes and we estimate the relationship of JPY/CHF/gold with these risk proxies. We then use these estimates to calculate JPY, CHF, and gold’s responses to both a hypothetical 10% drop in equities and a 50-bps decline in US 10Y yields. Our estimates are based on data spanning approximately the last two years, using daily returns.
For the equity risk proxy, we use the MSCI World Equity Index (in local currency) ex-US. Due to the US fiscal stimulus, US equities have outperformed the rest of the world’s stock markets; hence excluding them will give us a more accurate measure of global risk appetite.
Results are illustrated in charts 1 and 2, where we have estimated the relationships over three different time windows: since the beginning of 2018, over the last year, and finally, over the last six months. The estimates have the “right sign”, meaning that a decline in global equities (or a drop in US yields) is associated with a rise in the price of safe havens.
Results suggest that there is a clear pattern showing that, overall, gold is more sensitive and hence the most effective hedge amongst the three instruments we test. Using the example of the last six months, a 10% drop in world (ex-US) equities would likely trigger a 4.6% rise in the price of gold. Similarly, a 50-bps decline in US 10Y yields (corresponding to roughly a 4.7% rise in bond prices) would generate a 5.6% increase in the price of gold. JPY is also proving to be an efficient hedge – though to a lesser extent than gold – while the CHF, although still offering some protection, is the clear laggard. We will now discuss each one of them in greater detail.
Gold: A solid hedge against risk-off episodes
Our empirical results show that gold has the highest negative correlation (amongst the currency + gold complex) with risk assets and US yields. This explains its 8% performance so far this year, on top of its 18% gain registered in 2019. What has made gold such a sought-after asset this time around is the fact that negative interest rates in Europe and Japan have brought a fundamental change to the relative merits between safe havens. In short, negative yields imply that there is a cost in holding European or Japanese sovereign fixed income securities which, consequently, has propelled demand for gold (including for hedging purposes) significantly higher.
We do acknowledge that long positioning is quite stretched and that the gold price is at its highest level since 2013. However, we believe that a full-blown risk-off episode associated with a global pandemic could see gold gaining further (gold was trading at a higher price in 2011-2012, between USD 1,700 and USD 1,800 per ounce during the European debt crisis), especially as such a crisis would imply even looser monetary policy, mostly by the US Federal Reserve (Fed).
Therefore, we still believe in gold’s hedging attributes.
JPY: Still an effective hedge
USDJPY has risen by 2% this year, a somewhat unintuitive performance given the market risks. However, the yen was holding up much better until last week when USDJPY rose by 1.7% to 1.12. Some commentators attributed this recent JPY weakness to fears about a potential Japanese recession following the weak GDP data for Q4 as well as the spread of virus infections in Japan. We do not subscribe to these speculations. Historically, there is no correlation between negative Japanese GDP growth and USDJPY, while natural disasters have seen Japanese investors repatriate money into the country, putting upwards pressure on the JPY as Japan is a net creditor to the rest of the world.
We think the recent JPY weakness was mostly a result of an increase in fixed income-related outflows from Japan. So far this year, Japanese investors have bought a net amount of JPY 4.7 trn (USD 42 bn) compared with an average net buying amounting to JPY 0.7 trn over the same period since 2015. Some of these flows may be linked to the GPIF (Japan’s government pension fund), which is expected to soon release its new model portfolio allocation showing an increase in the target of foreign bond holdings. With rates abroad still a lot higher, especially in the US, a large chunk of these debt-related outflows are likely running with lower hedge ratios, thus having a softening impact on the JPY.
While some of these outflows may have further to run, it seems that the biggest chunk has already been allocated, hence foreign bond buying is likely to slow. Furthermore, historically equity flows have been more important for the JPY than fixed income flows. In a risk-off environment, liquidation of existing foreign equity exposures could make the JPY stronger. Accordingly, we would not extrapolate the yen’s weakness from here – in fact, recent days have seen USDJPY returning to the below-111 area.
Putting everything together, historical empirical evidence suggests that JPY would remain an effective hedge currency against an intensification of the virus outbreak.
CHF: Still offering some protection, but modest in magnitude
We have discussed on numerous occasions that since 2015, the CHF has offered noticeably less protection against risk sell-offs when compared with previous years/decades. This is likely linked to the deeply negative Swiss interest rates that make holding Swiss francs very expensive. That said, EURCHF has experienced quite a notable decline since October of last year, dropping from above 1.10 to nearly 1.06 as of now. While the recent virus outbreak has certainly played a role in CHF strength, there have been two additional forces at play. First is EURCHF’s close correlation with EURUSD, which has depreciated by 3% so far this year, and second is the improving Swiss trade balance, which coincided with local investors’ unwillingness to recycle this abroad via portfolio outflows (as discussed in our recent G10 FX monthly). Against these CHF-supporting factors, the Swiss National Bank (SNB) has been intervening in the currency market, selling Swiss francs in an attempt to stop or slow CHF appreciation.
Putting everything together, including our empirical findings discussed in the previous section, we believe that if the virus outbreak escalates further, EURCHF downside could intensify, but is unlikely to become too pronounced. The SNB – which appears determined not to allow the pair to drop materially below 1.07 – would increase currency intervention and potentially cut interest rates further. Admittedly, the room to lower interest rates is not great (the policy rate is at -0.75%), but the central bank would have to be creative with a loosening monetary policy mix given that inflation is running close to 0% YoY and the pass-through from EURCHF to Consumer Price Index is quite strong. The upshot here is that while CHF can offer some hedging protection, it is unlikely to be the hedging instrument of choice in the event of an escalation of the virus outbreak.
USD: Still a risk-off play, but mind the headwinds
The dollar has clearly benefited from the global trade disruption in 2018 and 2019, and started this year as well on strong footing as virus-related concerns influenced investors’ risk appetite (+2.5% YTD on a trade-weighted basis). In simple terms, the USD represents the world’s reserve currency, which implies that any event with a high risk of dampening global growth results in more demand for dollars. This is compounded by the bets of speculators, who – being aware of USD’s counter-cyclicality – attempt to “front-run” the market and bid the greenback higher on any negative worldwide news. This time around, the dollar has enjoyed two additional benefits. 1) It offers the highest interest rates among the G10 countries. 2) The US economy has been performing strongly over the past two years relative to the rest of the world – in large part due to the 2018 fiscal stimulus.
Consequently, the USD would likely be further supported if virus-related concerns lead to a full-blown market sell-off. In such a case (not our central scenario), we would expect USD strength to manifest itself mostly against: 1) cyclical currencies, and those whose central banks have some room to ease policy, i.e. AUD, NZD, and to a lesser extent, SEK and NOK; and 2) currencies exposed to Chinese growth and Chinese value chains such as THB, SGD, and KRW in Asia, and BRL and CLP in Latin America.
All that being said, we remain mindful of extreme valuations and USD political risks not being discounted adequately, which could come back to haunt the USD. First, the currency is overvalued by 8-12% by our estimates, and in line with IMF estimates. Although valuation considerations typically take a backseat in periods of market sell-off, the misalignment is too material to be completely dismissed. Second, with the Fed one of the few major central banks still having ammunition to lower interest rates, a dovish pivot by the Federal Open Market Committee (to counteract the virus impact and/or to address the persistent undershooting of inflation) could see the USD fall. Third, US fiscal impulses have started fading, reducing the US’s advantage relative to the rest of the world. Fourth, we believe the market is currently under-pricing the possibility of Bernie Sanders running in and winning the next US presidential race – a result that we judge as USD-negative given Sanders’ business-unfriendly agenda. Finally, the speculative community has increased dollar long holdings quite rapidly these past few weeks, making the currency prone to abrupt reversals.
Our central scenario foresees virus-related disruptions as material, but transitory. The aggregate data shows a continuing drop in new infections in China, which is consistent with this narrative. Hence, we expect a rebound in activity towards Q2, also aided by significant Chinese fiscal stimulus. This should see dollar strength reversing, USDJPY returning below the 110 level mostly because of USD weakness, and EURCHF rising only modestly towards 1.10 by year-end, as the bottoming out of global manufacturing regains traction.
However, the recent increase in infectious cases outside China (notably in Italy) means that a severe and prolonged risk-off episode remains a possibility. In such a case, the USD would stay resilient, while gold is likely to prove the most effective hedge across the currency + gold complex. JPY is also a good alternative hedge against risk appetite deteriorating sharply, while CHF would likely lag its peers, in large part due to the SNB intervening in the market. Outside currencies, exposure to US Treasuries should also help in navigating volatility.