Cutting central bank liquidity will hurt risk currencies, says Citi

While pessimism reverberates around the global capital markets, foreign-exchange investors remain solidly long riskier currencies, which range from the Canadian dollar to the Norwegian krone. However, the expectation that monetary authorities will automatically respond by adding more liquidity to the financial system should the global outlook remain gloomy, may be ill considered, says Steven Englander, global head of G10 strategy at Citi.

A key concern for those investors that are bullish on risk currencies is that central banks are more constrained in their provision of liquidity than they were in the past because of evidence of rising inflation, a weak dollar, and higher valuations in commodity and stock markets.

“These restraints should be given more attention since the policy response function has been a major driver of asset-market rebounds in past,” Englander wrote in a note published June 13. There is now scant public or political appetite in the US for further quantitative easing, he adds

As recently as August 2010, positions in risk currencies were overwhelmingly short -- now they are long across the board, in particular in respect of the Australian and New Zealand dollars and Norwegian krone.

“Investor positions, and we suspect pricing, largely continue to reflect optimism, but this time the assumed policy response may be much more limited than in the past two years, and probably less effective,” Englander says.