The role of sterling has changed from the old days as it loses its safe-haven shine, with implications for those invested in it. With unhedged currency exposure contributing to portfolio performance, we analyse the characteristics of the UK currency versus others and which currency hedging strategy might be most appropriate in a sterling investor’s equity portfolio.
News over the last two years has been dominated by a health crisis, sudden drop in economic demand, and Russia’s conflict with Ukraine. In this time, financial markets often treated the world economy as one big entity.
This is changing, as divergent, and soaring, inflation, monetary policy, and the resilience of economic activity becomes more apparent at a local level. For an investor, this is a good chance to reflect on exchange rate risks and opportunities.
The shifting role of currencies
The value of a currency is driven by many factors: access to natural resources, political stability, or an economy’s ability to produce sought-after goods, plus several more. Some currencies are considered to be cyclical because their worth relies on goods that are particularly linked with the economic cycle. Others are dubbed “safe-haven” currencies as they remain attractive when the global risk appetite decreases.
Sterling highlights how the role of currencies can change. It used to act as a safe haven for investors. It does not now. To show this point and the effect it can have, we analyse the ability of the UK currency to act as a safe haven against leading currencies over the last three decades.
Sterling a safe haven no longer
In analysing the currency’s exchange-rate trends, we applied a well-known concept from economic theory: Uncovered Interest Rate Parity. This postulates that future exchange rate changes are determined by today’s differences in interest rates between currency areas.
We then add a local currency effect (how sterling performed against other currencies, excluding the one being analysed) and a global risk factor, the option-implied volatility index (VIX), or “fear index”, from the Chicago Board Options Exchange.
Our analysis shows that sterling showed safe-haven characteristics against cyclical currencies such as the Australian dollar, generally, and also the Swiss franc, at least until the mid-2000s. The euro and the greenback fared better in turbulent markets during that period. Only the Japanese yen was a clear safe haven for sterling-denominated investors.
However, this changed drastically after 2007: the new triumvirate of safe havens (dollar, yen, and Swiss franc) has proved more resilient to market stress than sterling since then (see chart).