The political temperature continues to increase, based on growing expectations of a US-led military action against Iraq. Typically, in times of increased political uncertainty globally, the dominant theme becomes one of capital preservation and risk-reduction. In such periods there are frequently one or more currencies that appreciate, as investors flee to one currency.
In the recent past there have been periods of uncertainty when investors have flocked towards the safe haven instruments and currencies. One measure of these is the TED-spread, the yield gap between 3-month US T-bills and 3-month Eurodollars. This is an imperfect measure, based on the assumption that Eurodollars are always and everywhere a more risky asset than US government T-bills. While that is naturally and overwhelmingly the case, it may change if the perceived cause of the uncertainty and/or crisis is the US government itself.
However, in general this spread remains a good proxy for the degree of risk aversion in global financial markets, with the spread rising as risk-aversion rises.
It is possible to identify six spikes in the TED spread since 1990. These spikes, and their approximate cause, are shown in the accompanying table.
Recent Crises and the TED Spread
Bond market crash
Stock market crash
Source: B&M Research
Interestingly, some of the causes of the largest increases in the TED spread were largely located in the US itself: the Operation Desert Strom, the panic over Y2K, and the stock market crash of mid-2000 onwards.
Secondly, it is also worth noting how frequently these ‘extraordinary’ events occur, which belies the idea that prolonged periods of stability are the norm, either in terms of global politics or in terms of the financial market consequences.
Thirdly, it is also worth noting that, for those investors hedging themselves in the futures market, where the weight of Eurodollars is significantly greater than T-bills, the hedge against risk (say, of a new war) may be a far from perfect one given the divergence in the components of the spread.
In fact, the prospect of war would tend to suggest that this spread could spike higher, with a flight to T-bills and a potential sell-off in Eurodollars. It has frequently been the case that the leading currencies have appreciated versus the US dollar as this spread has widened.
Recent Crises in the TED Spread & Currencies versus US Dollar (% change)
Source: B&M Research
The cut-off points for the respective periods shown in the table above are:
1. The end of the US recession and Desert Storm in 1991
2. The recovery in bonds in 1995
3. Mid-1998, ie prior to the Russian default
4. The 12 months following the Russian default
5. The 6-month period to end-2000
6. The 12-month period following the peak in stocks to mid-2001
Traditionally, the explanation for currency safe-haven status has been the relative current account positions of the economies concerned. Over a very prolonged period both Japan and Switzerland have been current account creditor economies, while the US and to some extent the UK have been significant current account debtors. Since reunification, Germany has moved from creditor to debtor status, although that situation may now be improving. More significantly, for the euro, the EU-11 current account balance has followed the same trajectory as that of Germany since the advent of the new currency; switching into deficit over the period, at least until very recently.
However, a glance at the table above shows that in the most recent crises, the dollar has been the strongest major currency, despite the fact that the US current account has been on a widening trend. This is also shown graphically (above), where the US dollar’s appreciation since 1994 has coincided with a sharp widening of the current account deficit.
Clearly, the net flow into the US dollar has been positive during those crises, and given the simple arithmetic of the balance of payments, this must arise from the flows into the capital account and/or Foreign Direct Investment.
Therefore it is the attractions of US assets which have bolstered the US dollar during periods of crisis, even when the locale of the crisis is the US itself. This was the case certainly in the 2000 stock crash and arguably so with regard to the ‘Y2K’ issue, as the main source of the panic on this issue emanated from the US.
This flight to US dollar assets is not directly a reflection of US outperformance. US stock markets have been among the best performers, for example the DJIA rising by more than 200% since 1990, even after the latest rout. But clearly it was not the cause of the US dollar’s resilience in 2000, as the crisis then was the stock market’s decline.
But over the same period since 1990, US government bonds have been the worst performers of major bond markets and this despite the recent rally at both ends of the US yield curve.
The key issue is whether this same, more recent trend of US dollar appreciation will recur if crisis (war against Iraq) takes place. Here, the question is reduced to whether internationally-mobile capital is close to its benchmark, or not.
The US dollar may weaken for independent factors in the coming period, and it is always possible that the market positioning will change dramatically if war looks imminent. But, based on this analysis and current conditions, there is no foregone conclusion that the US dollar won’t appreciate if hostilities break out.