The US investment bank Lehman Brothers filing for bankruptcy in September 2008 triggered shock waves on the global financial markets. The foreign exchange markets were also affected by this. For example, within the space of one month, the yen and the US dollar appreciated sharply, whereas the Australian dollar and the Canadian dollar underwent a depreciation during the same period. In its July Monthly Report, the Bundesbank now looks at what impact financial market stress has on exchange rates. The Bundesbank economists come to the conclusion that exchange rate developments which take a similar course may sometimes have quite different fundamental causes.

In periods of calm on the financial markets, currencies of countries with high interest rates tend to appreciate sharply while it is more the case that low-interest currencies depreciate. However, if financial stress increases, this scenario often reverses abruptly. In troubled times, there is suddenly a demand for currencies of countries with low interest rates, whereas high-interest currencies often undergo considerable depreciation. As possible causes for this change in market conditions, the Bundesbank cites two strategies pursued by investors in the financial markets – first, the search for safe havens for their capital and, second, the unwinding of currency carry trades, ie risky speculative transactions in which investors seek to generate returns from international interest rate differentials.

Search for safety

In the first scenario, investors are looking to protect their capital in times of crisis. They thus invest in countries deemed to be particularly resilient to crises. Criteria for such currency areas are, for example, political and institutional stability, low rates of inflation and confidence in the central bank. Rising demand for various fixed assets in these countries leads to a corresponding appreciation in their currencies.

The strategy of unwinding carry trades is also chiefly motivated by the search for safety. Unlike "safe havens", the aim here is to exit a risky speculation strategy. In periods of calm, investors take up funds in a low-interest currency (debt currency) and invest them in a higher-interest currency (target currency). In simple terms, the interest differential is their profit. Initially, carry trades push down the value of the debt currency as this is where the capital outflow is recorded. However, if the value of the debt currency appreciates suddenly and unexpectedly and the investment currency thus depreciates, speculators stand to suffer considerable losses. In cases where financial stress emerges abruptly and risk propensity falls, investors therefore often unwind their carry trades. This may also prompt other investors to cancel their investment, too. In this way, a great deal of capital flows back into the debt currency all at once which then appreciates as a result.

Rainy day currencies

But which currencies are "safe havens" and which are used to finance speculative transactions? In an empirical study, Bundesbank economists analysed a large amount of exchange rate data for the period from 1986 to 2012. They used yields from a global share price index in times of varying levels of financial stress as an indicator for asset losses, setting this data in relation to changes in the exchange rate of a number of currencies. In this context, a "safe haven" currency is one that appreciates when the share index, as a reference portfolio, goes down in times of uncertainty and a control is simultaneously performed for the other determinants. In this connection, economists speak of "rainy day" assets.

The empirical results show that the Swiss franc and the US dollar are used as "safe haven" currencies. Taken in isolation, their exchange rates rise when the global equity market returns decline in times of high financial stress. By contrast, in periods of calm, the yen is used as a financing currency for carry trades, which are unwound in periods of stress, thus strengthening the yen.

However, the euro exchange rate behaves in much the same way in times of both high and of low stress. "This outcome is consistent with the observation that, even when the sovereign debt crisis was at its most intense, the euro depreciated only slightly against the currencies of the euro area's most important trading partners," say the Bundesbank economists.