When Safe Havens Fall

By Claus Vistesen

By far the most important bit of economic news this week came in well after Europeans had closed down for the weekend in the form of Moody’s decision to cut the UK’s credit rating. It was important because it added some colour to why GPBUSD crashed through support earlier in the week (wink, wink) as well as it crystallised just how poor economic fundamentals have now become in the UK

As always, Moody’s are coming in after the fact. It has been pretty obvious for a while that to term the UK as a safe haven only made sense if you believed that continental Europe would sink into ground leaving an open sea between Dover and the Ural. This was always going to be one of the more unlikely outcomes, but with the famous speech by Draghi that the ECB would do whatever it takes to preserve the euro, the wheels were slowly set in motion for a re-rating of all safe haven trades (and thus the EURGBP going vertical and the GBPUSD plunging out of its recent 3y range). 

The main question we are left with is what a safe haven actually is? Should we look at traditional macro fundamentals which would certainly, from a capital flows perspective, seem to offer a usable framework or is a safe haven simply what the market terms it to be?  

This is an important question to think about when considering global capital flows and carry trade fundamentals. Take Japan for example. It used to be considered a safe haven only 6-12 months ago. A high external surplus, deflation (generating positive real returns), and low volatility in the bond market were all factors. However, recently two things have happened. The first gives me hope that macroeconomics has not completely lost its usefulness. The fundamentals of Japan have simply changed for the worse. Growth has slumped, the external surplus has disappeared and the budget deficit has ballooned. Still, the second major change is that Japan through both its monetary and fiscal policy initiatives in the past 12 months has simply sent a signal that it does not wish to be a safe haven anymore. 

Indeed, Japanese politicians (and its corporates) would probably prefer that we went back to the days of the Yen carry trade. 

Cue of course the re-emergence of currency wars as a major talking point. However, the fascinating point about this report by Bloomberg (and similar reports) is that e.g. Australia and New Zealand are lumped together with Norway and Switzerland as “victims” of carry trade flows as a result of a race to the bottom among G4 central banks. 

This is fascinating because only someone deliberately ignoring even the simplest macroeconomic analysis would group these economies together. If you don’t believe I recommend a two step process; read up on simple open economy dynamics and then compare the twin deficits (budget balance + current account balance) of Australia, New Zealand, Norway and Switzerland. See the difference? 

The only reasonable explanation is of course that everything has been reduced to a hunt for positive yield. This makes sense in a world where ZIRP in all the major central banks force investors into any and every instrument that offers a positive nominal yield (never mind that the real yield which will probably be negative). I think this process is easy to rationalise, but to frame these flows in relation to safe havens makes absolutely no sense. 

What now appears to be UK’s fall from grace is a pertinent reminder and this leads me to the view the notion of a safe haven is probably one of the most mis-used concepts in the economics media today. Keynesians v Austrians would be another one (but that is for another day!). 

So what is a safe haven you might ask? Well I certainly don’t have the final answer, but I would suppose it should as many as the following characteristics as possible.

  1. Large, stable and structural external surpluses
  2. High net savings, strong net foreign asset position
  3. Positive government balances, stable and low domestic interest rate environment
  4. Non-volatile real return on base rate linked products
  5. Open capital account (ease of getting money in and out, but because of the strong current account currency volatility would likely be relatively low)
  6. Deep and liquid financial markets.

I am sure I have forgotten something, but it obviously occurs to me that such an economy does not exist today. It is better then to recognize this than trying to lump all kinds of different economies together as safe havens just because they offer positive nominal yield; because eventually even the most solid perceived safe haven may ultimately fall. Just look at the UK.

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