The search for income in FX markets

Currencies from secured commodity producers like the Norwegian krone and Canadian dollar will play a part in the eventual solution for Europe’s energy independence from Russia. This goes with our 2022 Income repression continues investment theme around the search for income in a low-yielding environment as high-quality cyclical currencies can offer an attractive interest rate for holding them and can also provide portfolio diversification benefits.

For investors actively seeking alternative sources of income, a popular strategy within FX markets is to invest in high-yielding currencies, funded by the sale of low-yielding currencies. In recent years, opportunities for this carry strategy have been limited given policy rates in most developed economies were near their lower bounds. However, since the second half of 2021, a few major central banks have turned more hawkish, while others have remained accommodative, cultivating a more fertile soil for such carry strategies. These high-yielding currencies have also tended to be from countries that are net-exporters of commodities, which have enjoyed broadly rising prices of late.

Within these higher yielding currencies, we tend to prefer oil-sensitive ones of secured commodity producing countries like the Norwegian krone and Canadian dollar. We can expect both countries to play a critical role in the eventual solution to Europe’s energy independence from Russia. While the green transition has deterred investments in fossil fuel production, this structural shift in the European demand for energy should reinforce the high demand for Norwegian and Canadian oil and gas over the interim transition years, given the low number of reliable alternative energy suppliers and the still limited supply of renewable energies.

As Norway is one of the world’s largest energy exporters in terms of percentage of GDP, current high oil and gas prices should provide some added support to the krone. We have seen significant improvements in Canada’s trade balance as well, which could continue if oil prices remain elevated.

In addition, high energy prices will have relevant positive spill-over effects on the domestic growth outlooks for both Norway and Canada, through boosted investment into the oil and gas sector, which in turn will favour employment, higher wage growth and a tighter monetary policy.

While the Australian trade balance has also improved, its evolution is less impressive than Norway’s or Canada’s, as Australia exports mostly coal and iron and imports oil products. Meanwhile, New Zealand’s trade balance is unsupportive to the New Zealand dollar, given the country exports mainly dairy products.

When it comes to carry, there are also some distinguishing factors between commodity currencies. The Norges Bank was the first developed market central bank to raise interest rates, while the Bank of Canada and the Reserve Bank of New Zealand have also already embarked on tightening cycles and signalled further rate rises, given high inflationary pressures. The Reserve Bank of Australia (RBA) has been rather patient so far, having yet resisted starting on a tightening cycle. That said, given Australia’s tight labour market and increasing inflationary pressures, the RBA could turn more hawkish and start hiking interest rates in the coming months.

Chart: Increased policy-rate spread makes carry strategy more attractive

Overall, as long as global risk appetite is resilient, investors’ search for yield should continue to favour high-yielding commodity currencies, while the structural diversification of energy demand from Europe could fuel some investments in expanded energy production. We see more supportive drivers for the Norwegian krone and the Canadian dollar than for the Antipodean currencies given their exports mix and the closer trade partnerships they have with Europe.

*G10 carry strategy based on buying the three G10 currencies with the highest short-term rate through the sale of  the three G10 currencies with the lowest short-term rate

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