What is a safe haven currency?
A safe haven currency is a currency that is considered to be safe during geopolitical and economic turmoil. Consequently, when events like natural disasters, war and stock market crashes occur, currency traders invest in safe havens, causing the value of the safe haven currency to rise and the value of currencies paired with it to fall, even though the events may not have had an obvious impact on the currency in question.
What makes a safe haven currency?
Due to the popularity of the carry trade, interest rate differentials have often been associated with safe-haven status. However, this trend isn't consistent across the market, as it only seems to be a factor when trading the currencies of advanced countries as opposed to emerging countries. This implies that the liquidity of the currency being traded is a driver of safe-haven status, as major currency pairs have greater liquidity than exotic currency pairs.
Also, when global risk aversion is high, liquidity in some markets may dry up, causing traders to invest in highly liquid currencies. In turn, this gives the most liquid currencies an extra boost.
For a country to be considered safe and low risk, it should be isolated from global events in case there is a crisis, and it should have good fundamentals, like economic management and strong industry. In theory, the currencies of such countries could be seen as safe haven currencies.
In practice, it is increasingly difficult to achieve isolation in an increasingly globalised world. So factors like the size of a country's stock market, which indicates its financial development and market size, now seem to outweigh the external vulnerability associated with its net foreign asset position.
Which currencies are considered to be safe havens?
The USD, CHF and JPY are all referred to as safe haven currencies. However, due to the carry trade the fact that the Japanese Yen rises in times of global turmoil is more likely to be a reversal of investors' carry trades (which usually go long on a currency with a high interest rate against currencies with low interest rates, like the yen) rather than an intentional investment in the currency.
The CHF is considered to be a safe-haven currency for a number of reasons:
1. Liquidity - the Swiss Franc is a very liquid currency and is paired with the USD
2. Switzerland has a highly competitive business environment, along with low corporate tax, a transparent economy and a history of good economic management.
3. Switzerland is traditionally neutral, so it is viewed as less likely to be affected by political turmoil in Europe than the euro.
4. The Swiss National Bank keeps a large part of its reserves in gold, causing the CHF to appreciate with the price of gold.
Although the CHF briefly fell from grace in the global financial crisis due to its exposure to the banking sector, it has since regained its footing as a safe haven currency, and has attracted investors as several members of the eurozone struggle.
Why is the USD a safe haven currency?
If we look at the factors that contribute to a currency being a safe haven, the US and the dollar don't measure up. The US is not isolated from global events, having major trading partners across North and Central America, Asia and Europe. The US has not fully recovered from the financial crisis, with unemployment still around 10% and growth having slowed again for the three quarters to June 2011.
So why aren't currencies like the AUD and CAD - both from countries that didn't suffer a banking crisis or a recession, and both of which have strong economies and lower unemployment rates than the US - considered to be safe haven currencies?
The AUD, CAD and NZD are all commodity currencies, meaning that, as commodity exports contribute a large about to their GDP, they usually benefit from strong commodity prices. Strong commodity prices are encouraged by a global economy, meaning that when the global economy might be in danger, these currencies fall in value as investors turn to safe havens.
Which brings us back to the question - why is the USD a safe haven currency?
The main reasons for this are the size of the US economy, including the widespread use of the USD globally, the belief in the USD as a safe-haven currency, and the liquidity of the USD.
The majority of fx trades involve the US dollar - the major currency pairs are all paired with the USD, and formulas to figure out exchange rates between crosses (currency pairs that don't contain the USD) use the USD exchange rate. As liquidity is how short-term currency traders make their profits, there are constantly many long and short trades taking place on the USD. In a risk adverse environment, we have already said that liquidity in some markets dries up. This causes more traders to invest in the most liquid currencies, of which the USD is at the top of the heap.
As the USD has been considered to be the world's top safe-haven currency for years, there is a prevailing sentiment in the market that the USD is safe, regardless of what the current economic data might show. This is one of the reasons why the USD strengthened in 2008 despite the financial crisis - it was still seen to be safer than other markets.
The main reason that the USD is considered to be a safe haven currency is that the USD is "too big to fail". Currently there are more US dollars in circulation around the world than any other currency, with two-thirds of the rest of the world's foreign reserves denominated in US dollars. If the USD falls by too much, it will have ramifications across global markets. The dominance of the USD, and the dominance of the US in world trade, means that other central banks won't allow the dollar to fail.
Check out my blog Talking Forex - a beginner's guide to forex to learn more about safe haven currencies. Also, the site of my preferred forex provider has a lot of good information on forex and forex trading, including examples and FAQs.
I am not a financial adviser, and the information in this blog is just intended to inform and not advise. Please remember that forex is a leveraged product, so it's possible to lose more than your original investment. Forex trading might not suit everyone, so please ensure that you fully understand the risks involved with this type of trading.
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