How is the COVID-19 pandemic impacting the FX market?

The US has leapfrogged China and is now the worst affected country in the world, having experienced a massive surge in the number of new daily cases in the past week. Mainland Europe has also been particularly hard-hit, most notably Italy, which has experienced more deaths due to the virus than any other country. Spain also appears to be on a similar trajectory, with Germany not far behind in terms of confirmed cases (Figure 2). For context, the number of active cases in Italy (i.e. the total number of cases minus those either fully recovered or deceased) now dwarfs the same number in China almost thirty-fold. In fact, the ratio of confirmed cases to deceased in Italy currently stands at approximately 9:1 versus 25:1 in China. This is likely due to two factors, the first being the still relatively lower levels of testing conducted in Italy compared to many other countries around the world, and Italy’s comparatively high median age (46.5 years versus 38.4 in China according to the Central Intelligence Agency).

Figure 2: COVID-19 Confirmed Cases [Europe] (26/02 – 29/03),

How are financial markets reacting to the crisis?

The reaction in the financial markets has been aggressive and violent and akin to the moves witnessed during the global financial crisis in 2008/09, if not sharper. Equity markets have borne the brunt of the sell-off as investors flee higher risk assets in favour of the safe-havens or, in many cases, exit the market altogether. US stock indices have stabilised, although are still down approximately 25% since mid-February at the time of writing, with equities in Europe lower by a similar amount. The FTSE 100 index, for instance, has tumbled to its lowest level since 2011, having shed one-third of its value in under three weeks (Figure 3). Large scale intervention on the part of central banks and governments has helped to some extent, although it has far from fully restored investors confidence.

Figure 3: S&P 500 and Dow Jones Industrial Average Indices (March ‘19 – March ‘20), In the FX market, the most popular trading strategy throughout much of the past few weeks has been for investors to buy the US dollar, particularly at the expense of emerging market currencies. The dollar has acted as the safe-haven currency of choice among traders during the crisis, as it has tended to do during times of intense market stress in the past. We outline below the three main reasons why we think the dollar has outperformed:

1) It is the most liquid currency in the world.
2) The US economy is less reliant on external demand than much of the developed world, particularly Europe.
3) The spread of the virus has been relatively less aggressive in the US than in Europe and Asia throughout much of the outbreak, particularly as a percentage of the total populus. An increase in the rigorousness of testing in the US has, however, led to a sharp increase in the number of confirmed cases there, with the country having now overtaken China as the worst affected country in the world.

In trade-weighted terms, the dollar appreciated by 8% in the ten days or so from 10th March, although it has since given back some of its gains. The main EUR/USD pair has suffered from a very volatile few weeks, initially rallying sharply before crashing to a near three-year low below the 1.07 level. Now that the Federal Reserve has cut interest rates all the way down to zero, the reason for investors to buy the euro in the expectation of a narrowing in US-Euro Area interest rate differentials is now gone. Among the other major currencies, the Norwegian krone and Australian and New Zealand dollars have been among the most exposed, as has sterling. The UK currency fell to its weakest position versus the US dollar since 1985 on 18th March (Figure 4). Measures of implied volatility in the pair have sky-rocketed and have exceeded levels witnessed following the Brexit vote in June 2016 during the current crisis – levels that were deemed as unlikely to be reached again in a generation. We attribute the extent of the sell-off to investors unwinding their long GBP positions put in place following the UK election in December, and the pound’s higher risk premium due to Brexit and the country’s large external deficit.

Figure 4: GBP/USD (February ‘20 – March ‘20), In the emerging market universe, a host of currencies have fallen to multi-year lows. Among the worst affected have been the currencies of countries that are heavily dependent on the production of commodities, particularly given the sharp sell-off witnessed in oil (down 70% in around a month). The Russian ruble has been among the worst affected, shedding around 16% of its value against the dollar so far in March alone. Elsewhere, the Mexican peso and Colombian peso have also experienced dramatic losses, with the Brazilian real and South African rand not far behind and down in excess of 10% this month at the time of writing. Further losses from current levels for these high-risk currencies are possible, in our view, while the virus is yet to peak in the key economic areas around the world.

Figure 5: FX Performance Tracker [select currencies vs. USD] (March 2020),

How could the containment measures impact the global economy?

We have begun receiving the first few pieces of economic data that show the true impact of the virus containment measures on the global economy in the past few days. Following the disastrous PMI numbers out of China, the composite indices in the Euro Area (31.4), the UK (37.1) and the US (40.5) all tumbled to record lows (Figure 6). Initial jobless claims in the US also sky-rocketed to 3.3 million in the week to 20th March, almost five times the peak recorded during the financial crisis.

Figure 6: US, Eurozone & UK Composite PMIs (2017 – 2020), Central banks have attempted to leap to the rescue in the past few weeks. The Federal Reserve led the way, cutting rates by 150 basis points to the effective lower bound while restarting its large-scale asset purchasing programme. A host of other central banks have since followed suit, either by cutting rates aggressively or by pumping liquidity into the market. The main issue for central banks is that there is only so much that they can do in the face of a health crisis. Policymakers cannot print a vaccine, nor can they get consumers through the doors of shops when the shops themselves are not even open for business. The most effective measures will instead, we believe, be those that target the most at-risk businesses, namely SMEs. This assistance has come in the form of measures such as debt forbearance, low-cost loans and government grants.

While we think that the aforementioned stimulus measures should help ease the blow, we believe that it is now not a matter of ‘if’ the global economy will enter into a recession, but how significant and protracted this downturn will be. Given the severity and breadth of the containment measures, it is likely to be a very severe one that, in the short-term at least, eclipses the great financial crisis of 2008/09. That being said, we remain hopeful that the global economy will bounce back sharply once the worst is over and the containment measures are gradually lifted. With governments ready to do whatever it takes, the goal of returning to an almost intact economic structure as soon as the epidemic is brought under control may be a reasonable one. In the case of each individual country, we believe that a lot will depend on the structure of their economies and authorities’ help to mitigate the negative impact of the virus on businesses and households. We think that the latter is crucial.

What could happen next?

With no historical precedent to draw upon, it is incredibly difficult to make any sort of accurate forecasts, particularly in the medium- to long-term. What we do know is that volatility in the market is almost certain to remain sky-high for now, particularly while the virus is yet to peak in the key economic areas around the world, namely Europe and the US. In the immediate-term, we may continue to see the dollar act as the safe-haven currency of choice, although the sharp increase in the number of cases we are seeing in the US is likely to limit the currency’s appeal.

As far as emerging market currencies are concerned, we think that the direction and size of the moves will be largely idiosyncratic and, in large part, dependent on each individual country’s macroeconomic fundamentals in addition to other factors (such as market positioning and liquidity). The three key indicators we look at here are: i) FX reserves relative to months’ worth of import cover, ii) external debt as a % of GDP and iii) current account balance as a % of GDP. We outline below these indicators for a select ten emerging market currencies. Those with the strongest fundamentals, i.e. high FX reserves, low external debt and either surpluses or small deficits in the current account are, in our view, better equipped to weather any potential further sell-off in risk assets that the COVID-19 virus may induce. We have denoted those that we believe could hold up the best in green, and those most exposed in red.