Currencies are affected by a huge range of factors individually, and the drivers of a currency can vary massively over time.
One thing that’s pretty constant is the classification of currencies as high beta or low-beta.
Beta is a measure of a currency’s volatility in relation to the overall market:
- High-beta currencies are riskier & offer higher potential returns
- Low-beta currencies are less risky & offer lower potential returns
Interest rate differentials are an easy rule of thumb method to define beta at a glance:
- Higher interest rates = higher beta
- Lower interest rates = lower beta
Let’s get a handle on this by grouping and ranking the currencies:
As with any generalisation, you can definitely pick some holes in it (e.g. categorising the EU as low political risk is a bit dodgy even though there IS an assumption of stability/continuity nowadays).
Leaving the little nuances aside, let’s go through each group…
High Beta Currencies
Emerging economies where economic growth is typically fast and unequal, political risks, debt and volatility are high.
Interest rates are higher in these economies because investors demand a higher risk premium to compensate for the uncertainty (of defaults, instability, regime change etc.)
e.g. TRY, ZAR, MXN, BRL, RUB
Cyclical / Activity Currencies
Developed economies where economic growth is steady, political systems are stable, and capital markets are well-developed.
Interest rates are lower than emerging economies. Investors demand a lower risk premium because of this relative stability.
Cyclical currencies are highly sensitive to the global economic cycle, and tend to rise in value as global economic activity rises. e.g. GBP, AUD, NZD, NOK, CAD
King USD: The Global Reserve Currency
Mixed Beta: The dollar needs a category of its own (and it can ‘float’ between cyclical and safe haven, it was even a funding currency at one point)
As the largest global economy, if the US does well, the rest of the world does too.
When the US economy is roaring and leading the pack, the dollar typically strengthens.
When the rest of the world is catching up and/or growing at a faster rate, the dollar typically falls in value.
When global growth slows, the dollar acts as a safe haven and typically strengthens.
The Dollar Smile 👇
Because the dollar is the global reserve currency, US interest rates have implications for the entire world.
As a rule of thumb, US rates represent the risk-free rate.
The Risk Premium is essentially the amount of extra insurance an investor will demand to put their money into riskier investments rather than parking it in ‘risk-free’ assets (such as US treasury bonds).
Safe Havens & Funding Currencies (Low Beta)
e.g. CHF, JPY, EUR
Arguably, USD is the one true safe-haven: the largest economy, bond market, and military superpower.
The Swiss Franc also benefits from safe-haven status, due to its exceptionally stable government and financial systems, tax-haven status and geopolitical neutrality.
Then there’s the Japanese Yen, which is more of a funding currency than a safe haven.
Investors tend to use JPY for carry trades. Essentially, they borrow Yen to fund the purchase of higher yielding foreign assets.
In times of economic stress, those trades are reversed (carry trade unwind) so Yen demand increases and the Yen strengthens.
The Yen is also considered as a safe-haven so there’s a self-reinforcing belief too.
The Euro was used as a funding currency due to low/negative interest rates pre-Covid. The fragmented political situation means it is unlikely to ever become a safe-haven.
The Dollar Index (DXY) Explained…
Here’s the weighting of currencies in the Dollar Index (DXY)
57.6% EURO!!!
There’s a huge correlation between USDEUR & DXY because of this weighting.
It pays to keep an eye on the currency pairs directly – DXY moves can be more to do with the euro than the dollar!
Key takeaway: Currencies can be grouped.
Generally, what’s good for one within the group will be good for the others…