Tell me again ...what makes a safe haven ?

Tuesday 3rd October 2017

ref :- "Havens are not always a place of safety" , Currency Analysis in the Financial Times

There's a danger that we might just be rehashing old ground here ("and when has that ever bothered you before", they cried) , but blame it on Kim Jong Un. There have been enough people requesting a clarification of what markets are looking for in a safe haven to warrant another visit.

In essence, the conversation always starts something like :

"N. Korea has shown that it has the capacity to build increasingly large nuclear bombs, right ? And they've also shown that they've got the missiles to deliver them, yes ? Now they're flexing their muscles by lobbing those missiles over the top of Japan, and you're telling me that the safe haven of choice is ..... the JAPANESE YEN ?!? Forget capital flows and foreign assets, that's just madness ..... "

It's hard not to have some sympathy with the point of view, particularly as we too have often pointed out the irony -- and the apparent illogicality -- of such market action. If you're struggling to get your head around the principle of the "Yen as Safe Haven" when Japan is likely to be one of those most under threat if young Kim really does lose the plot, you're certainly not alone. As Derek Halfpenny, MUFG currency strategist points out : "the clients don't get it". Truth be told, we'd be happier finding another refuge but it's never a bad thing to remind yourself about why markets react the way they do.

Some safe havens come in and out of fashion, others -- like gold -- have always been in demand in stressful times. Some aficionados have even suggested that bitcoin might have the credentials to qualify as a safe haven asset, though we might find investing in something as volatile as cryptocurrencies does little to reduce the stress levels.

But as far as traditional, fiat currencies go, the Dollar, Euro, Yen, Swiss franc, Scandinavian currencies and Sterling have all had their time in the sun in the past. Brexit-bothered Sterling is currently anything but a safe haven, and the go-to currencies most recently have of course been the Swissie and the Yen.

Each time a perceived safe haven currency gets bid up at a time of crisis, academics and economic eggheads like to argue over how much of the move can be put down to the inherent safety of the rising currency, and how much of it is a reversal of the huge volume of carry trades for which it was the funding currency.

***Reminder : The Carry Trade ......When volatility is LOW, traders borrow in low-yielding currencies (e.g. Swissie and Yen), which they sell to fund purchases of high-yielding currencies, and profit from the difference in yield. So for example, the effect of a Yen carry trade is to weaken the Yen. But at a time of crisis when volatility climbs, the Yen strengthens as traders rush to unwind their carry trades and buy back their short Yen position.

One might hazard a guess that in the current circumstances and taking geography into account, those academics might decide that in the case of the Yen, the carry trade argument carries slightly more weight than the "inherent safety" claims of anywhere in that part of the world.

How big a factor is the carry trade ? Unsurprisingly, the Dollar was considered the second-best safe haven currency behind the Yen for years though plainly it's remarkably weak performance this year shows that it no longer qualifies. But Bank of America Merrill Lynch reckon that it lost that status back in 2014, when the Fed's quantitative easing measures were coming to an end and those of the Bank of Japan and the ECB were just beginning (or were about to). That meant that generally speaking the Dollar was strong on the back of rate differentials working in its favour, but because of the use of Yen and Euros as funding currencies, they became the ones to strengthen in "risk-off" times of crisis as carry trades were unwound.

What does a currency need to be a safe haven ? According to Jane Foley of Rabobank : strong liquidity, a well-respected legal system, a strong budget position and a current account surplus -- and this surplus element is another reason behind the Yen's attraction as a haven. So huge are Japan's holdings of foreign assets, the Yen acts like a safe haven even when the crisis in question is in Japan -- it's all about repatriation. In the five days after the Japanese tsunami and earthquake in 2011, the Yen actually rose by 8% as money headed home. The US (and certainly the UK) can only dream of such surpluses.

Norway has a large surplus, and in many ways would qualify as a safe haven but it fails the liquidity test -- the Norwegian Krone markets are just too small to satisfy investors, and the same can be said for its Swedish and Danish cousins. And then there's Switzerland, where there's a current account surplus AND enough liquidity in the Swiss Franc to allow it to rival the Yen as the favoured haven destination. In fact, it was No. 1 on the list during the financial crisis and the Greek debt shenanigans. But Swiss threats to intervene in the markets to weaken the Franc have undermined its attractions somewhat.

Which is a good lesson ..... conditions that make something a safe haven change. Investors can't blindly assume that the Swissie and yes, the Yen too, are always going to be the place to put their money when the going gets tough. Sooner or later, they won't be and investors should be disciplined about reassessing the qualifications of any haven any time they're tempted to switch their money that way -- even if they have to do it in a hurry.

There's always gold of course ..... which does remain a destination when things are looking shaky. The trouble is, at any particular time it might not have too much else going for it -- it's already off $80 per oz from recent panic-fueled highs. There are dangers in the gold market, and you may have to be even quicker getting out when things calm down than you were getting in when things began to look dicey.

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