Tackling currency weakness

It seems easier to apportion blame for the yen’s slide when the BoJ has refused to hike policy rates in the same way as we’ve seen in other G10 countries – including Sweden

Much of the focus in the market has been on Japanese policymakers and how they have tried to prevent excessive yen volatility (meaning yen weakness), but the Swedish Riksbank is arguably in an even worse position. The real trade-weighted value of the krona has fallen by more than 25% since the start of European Monetary Union in 1999 while the likes of Finland, which joined EMU, has a real effective exchange rate that’s now 1% above the opening EMU level while Denmark, which shadows the euro, is also around 1% above the level seen when EMU started. The IMF estimated back in July that the krona was undervalued by around 10% at the end of 2022 on a real effective basis while the yen was fairly valued in spite of BoJ and MoF complaints about its fall.

Another point in comparing Japan and Sweden is that it seems easier to apportion blame for the yen’s slide when the BoJ has refused to hike policy rates in the same way as we’ve seen in other G10 countries – including Sweden, of course. The BoJ’s past decisions to give 10-year JGB yields a bit more licence to rise might have helped stem some of the yen’s weakness but, without higher short-term policy rates it looks as if the BoJ will continue to struggle, at least until other central banks start to cut rates.

In Sweden, however, rates have been raised which seems to suggest that currency weakness is not just a simple equation that runs off the back of poor interest rate differentials. This being said, the 3.75% policy rate in Sweden is lower than most other G10 countries, bar Japan and Switzerland, while its real rates are very low by virtue of the fact that headline inflation is well above most others at 9.3%. This could be the source of krona weakness, alongside the fact that high household debt levels and real estate fragility is causing some nerves right now. If this is the case, then there’s a problem that aggressive Riksbank rate hikes to support the krona would probably spur significant debt/property angst and likely contribute to krona weakness, not strength. And besides, as we said at the start, weakness in the krona – and the yen – seems a long-term issue and not just an issue over the past year, or two.

One Riksbank member, Floden, argued yesterday that speculation could be part of the reason. We think he has a point, and it is the same with yen weakness. We feel that there are particular characteristics of these FX markets that make the yen and krona vulnerable. In the case of the yen, the FX market is very heavily influenced by short-term speculative traders, most often individuals, who try to avoid the low rates on offer in Japan by carry-trading their way into higher-yielding currencies.

This is one reason why the CFTC data on yen positions usually shows that speculative traders are short of the yen. In the case of the krona, we think the currency suffers from its relative illiquidity. It is the least heavily traded developed currency with daily volume estimated at USD41bn out of a total market of USD7.5tr. Admittedly, it does stand above the Danish krone (with USD10bn) but hedge fund volumes in the DKK are just 354m against 4.8bn for the SEK, suggesting that speculators are far more active in the SEK than DKK. But why should low volumes and high speculation weaken the krona?

We suspect that the broad downtrend is due to the fact that the krona suffers much more than others when there is a period of heightened risk aversion; just as we might expect lower-liquidity emerging market currencies to fall during such episodes. Clearly we have had a number of such episodes in recent years. If this is correct it rather suggests that there is very little the Riksbank can do about it – including more aggressive rate hikes. In time, the krona will likely recover, but only when the world becomes a more risk-loving place and that might happen until the Fed starts to ease.