Covid-19. If we didn’t know what that was before this week we certainly do now. What was perceived as an Asia specific epidemic has spread to Europe and US. It has yet to be declared a pandemic. If it does then expect another leg lower in risk sentiment. Why? Pandemic means it is a cross boarder crisis and that a universal protocol will be enacted causing events, travel and the consequent investment and spending associated with this to dip sharply. Markets are fearful and as always start to price in scenarios before they happen. We live in a world, post crisis, that still has huge amounts of liquidity in the system (low rates, QE) which means the path of least resistance for risky assets is to drift higher while volatility remains low. Remember everyone saying how expensive equities were? That was because there was too much money washing around chasing too few assets, pushing them higher. This works fine until there is an event or crisis which brings a sharp reality check / increased risk to the environment that brings about these inflated asset prices. It is a bit like being on an escalator up before getting into a falling lift.
What does all this mean for fx? On the face of it in times of stress there are 3 ccy that benefit: USD, CHF, JPY. What has actually happened this time around is that as the stress has grown so too has the need to unwind big risk positions. In the initial sell off, the moves are fairly sharp but orderly. However, as the stress continues and deepens more disorderly and indiscriminate moves take place as investors and institutions unwind much bigger trades that ordinarily would hold. A rush for the door type exit. Towards the end of the week we see this particularly in the euro, which despite having the least chance of an immediate and coordinated response has been strengthening against not just the pound but also USD. This is because it has been used as a funding a currency and the carry trades big funds and institutions had put on are being unwound. What is a carry trade? It is when they have borrowed in stable, low interest rate currencies, like the euro (at v low interest rates) and then invested that back into higher yielding assets, in this instance mostly in USD. If this is unwound they need to sell their US assets therefore, selling their USD and buying back their funding ccy the Euro. Hence the euro’s recent strength. This move has been exaggerated vs GBP where the pound has weakened vs Euro as it has been on the end of the double whammy of Euro strength and GBP weakness given PM Johnson’s talk of walking away in June if trade talks don’t materially progress.
Can we be positive? Yes, firstly this is an influenza virus which like most spread best in winter and winter is almost over. Second, those that can cut interest rates probably will do so to shore up sentiment and those that cannot will look to spend. This is important as Europe is notoriously slow to react due to the complex nature of its union of differing cultures, economies and language and like any difficult conversation, a time sensitive crisis will sharpen minds and add impetus to creating a co-ordinated response. So don’t rule out some form of fiscal related stimulus in Europe either in the form of relaxing debt limits, tax breaks or actual spending / demand side stimulus in the near or medium term. Any globally co-ordinated stimulus would, medium term, be very positive indeed.