Major developed currencies, on the other hand, such as the euro and the pound have not been hit very hard at all. Euro/dollar, for instance, is still inside the 1.05-1.10 range that has been in place for much of the past fifteen months. Does it prove that not all ‘risk’ is equal?

There’s many different ways to measure “risk” when it comes to spillover to the FX market. The VIX index could be probably the best and certainly seems to correlate quite well with the level of the US dollar. This being said, it understandably correlates far better with “riskier” currencies, such as those in emerging markets. The correlation with developed currencies like the euro, yen and pound is still evident, but weaker.

The discrepancy arises largely because just about all “riskier” currencies tend to fall against the US dollar when perceptions of risk increase, whatever the reason, while, for major developed currencies, much depends on why risk has increased. We can best show this by using some examples of major risk events in recent years.

There was the global pandemic that began in early 2020, Russia’s invasion of Ukraine in February 2022 and the more recent tensions involving Israel, starting with the Hamas attack on Israel last October. But only one of these, Russia’s invasion of Ukraine, caused the US dollar to strengthen significantly against other major currencies such as the euro and the pound.

There was some very brief US dollar strength once the pandemic broke in early 2021 but this was over very quickly and for 2021 as a whole, the US dollar fell by over 7% against other major currencies. And, as we’ve just mentioned, the US dollar has only risen modestly in response to the recent tensions in Israel. In fact, the DXY index that measures the US dollar against other major currencies is still slightly lower today than when Hamas launched its attack on Israel last October.

So why is it that euro/dollar and other major currencies seem to respond to some risk events but not others, whereas EM currencies seem to fall in response to all risk events, no matter what their cause? There could be many answers for this. For instance, if risk produces an unwind in carry trades, these are more likely to be prevalent in the higher-yielding EM currencies than developed currencies. The US dollar’s role in international loans to EM countries is greater than it is in the developed world and hence, if risk events lead borrowers to cover or repay US dollar loans quickly, we might see a uniform weakness in EM currencies when risk rises.

There’s another argument, that Steve Barrow, Head of the Standard Bank G10 Strategy, prefers to focus on, because it may have relevance to the current surge in risk, and it relates to the reason why risk is rising. For in his view, the Russia/Ukraine conflict led to sharp weakness in major DM currencies such as the euro and pound against the US dollar because there was a very adverse terms of trade shock to the EU (and many others) from the resultant surge in energy prices, particularly gas, that was not felt anything like as much in the US given its relative energy self-sufficiency.

In contrast, the pandemic, back in 2020, did not produce huge terms of trade divergence and, so far at least, nor have the current tensions in Israel. If this is the correct way to view things, then significant vulnerability will only develop in currencies such as the euro and the pound if the conflict in the Middle East leads to adverse terms of trade effects for Europe relative to the US. This could clearly happen if tensions in the Middle East effectively close down the passage of oil through the straits of Hormuz.

“It is this that we will be watching closely for any signs that euro/dollar, for instance, could fall below parity and even challenge the lows of near 0.95 that we saw after several months of fighting in Ukraine in 2022. We certainly think it is more important than what the market seems to be focussing on right now, which is the scope for policy rate divergence between the Fed and ECB”, said Steve Barrow.