Faced with an unpleasant choice between the excessive volatility of high-yielding emerging-market currencies and the stability but near-zero interest rates of the dollar and yen, foreign-exchange traders are shunning both.
Instead, they're flocking to the five second-tier members of the G-10, a club of industrialized economies with fully convertible, internationally traded currencies. While the top five "majors" -- the dollar, euro, yen, pound and Swiss franc -- have all struggled, the bottom five "juniors" -- the Australian dollar, the Canadian dollar, the Swedish krona, the Norwegian krone and the New Zealand dollar -- have posted strong gains throughout the summer.
Call it a compromise investment. For this group, a comparatively stronger economic growth outlook offers modestly higher returns than the currencies of the bigger economies, but it also provides the stability now absent from emerging markets, where currencies such as the Brazilian real and Indonesian rupiah have seen their stellar performances from 2009 through 2011 give way to persistent declines.
Yet even in this Goldilocks not-too-hot, not-too-cold scenario, dangers lurk.
The biggest risk: policy traps. The governments of these countries are known for their by-the-book, noninterventionist approach to markets. In fact, it's one of the reasons traders ascribe lower risk to their currencies than to their emerging-market peers, whose governments often can't help meddling with prices. But as the Swiss National Bank demonstrated with its decision to cap the Swiss franc's value versus the euro, a rising currency can generate such pain among domestic industries that policymakers can be pushed into draconian solutions.
For now, buying the G-10 juniors has been a profitable summer trade, with gains since June 1 ranging from 4% for the Norwegian krone to 10% for the Aussie dollar. Over the same period, the Brazilian real weakened by 0.4% and the Indonesian rupiah declined by 1%.
The commodity price rallies of prior years contributed to the overall strength of these economies, since the export income and investment they generated helped put their finances on sound footing. They were all also blessed with relatively healthy banking sectors, which spared them the worst of the 2008 financial crisis and meant that their public finances were protected in a way that Europe's and the United States' weren't. Meanwhile, institutional factors -- their high state of economic development, trusted judiciaries, and open capital accounts -- mean these five economies aren't perceived to carry the same capital flight risk that still dogs emerging-market currencies.
Yet the attraction often also lies in the somewhat arbitrary differential between the interest rates set by these countries' central banks and the lower ones of the U.S., Japan, the euro zone, the U.K. or Switzerland. An investor can borrow cheaply in yen, where the benchmark rate is 0.10%, and invest the proceeds in higher-paying Australian dollars, where the Reserve Bank of Australia sets a policy rate of 3.5%, for example. The difference, known as "carry," provides a comfortable profit -- until the Aussie dollar falls.
But while this carry equation might seem logical, it's not sustainable forever. To the extent that their currencies keep attracting flows that don't want to go anywhere else, tensions will rise, just as they did in Switzerland. That's especially so if commodity prices are also weakening, as is the case for Australia's iron ore.
These economies have built their reputations on a commitment to free-market principles, and their governments are not likely to throw that out in a hurry. But no central bank, no matter how independent it claims to be, is completely immune to political pressure from exporters and domestic industrial lobbies. Already, central banks from Australia to Norway are bucking tradition and warning about the strength of their currencies. Whether they turn that rhetoric into action will determine whether the summer-long rally in the G-10 juniors ends in smiles or tears.
Michael Casey is managing editor for the Americas at DJ FX Trader, a foreign-exchange news service from Dow Jones Newswires and The Wall Street Journal. His new book on the global financial system, "The Unfair Trade," was published in May. Write to Michael Casey at Michael.J.Casey@dowjones.com.