Euro finds its niche as a funding currency

SAN FRANCISCO (MarketWatch) — With the European Central Bank’s key lending rate at a record low, the euro has emerged as a funding currency in so-called carry trades — a practice of selling weak, low-interest currencies to buy higher-yielding assets.

A “combination of low, short-term borrowing costs relative to most other currencies and the diminished likelihood of an extended appreciation … have enhanced the euro’s attractiveness as a means of funding carry trades,” said John Lonski, chief economist at Moody’s Capital Markets Group.

In a carry trade, investors sell or borrow against low-yielding currencies to fund investments in higher-yielding currencies, such as the Australian dollar.

The euro is currently fitting the bill of a lower-yielding currency after the ECB earlier this month lowered its key lending rate to a record-low 0.75% from 1% to support the ailing euro-zone economy. Read more on the ECB rate decision.

“The simple fact the euro received a shot in the arm from the ECB, ultimately expanding the monetary base, could make a case for the euro to become a favored currency in carry trades,” said Robert Fuest, chief operating officer and head of investment research at Landor Fuest Capital Managers. “This is obvious in the fact that it has ultimately become less expensive versus other major currencies.”

The U.S. dollar and Japanese yen had been instruments for carry trades with central bank interest rates in the U.S. and Japan near zero. The shift to the euro as a funding currency removes some downward pressure on the dollar and yen. That’s not necessarily a good thing for the U.S. and Japan, whose exports benefit from cheaper currencies.

Against the U.S. dollar, the euro EURUSD recently sank to a two-year low and the euro EURJPY has fallen to its lowest level since 2000 versus the yen. Currency exchange-traded funds have also reflected the move: quarter to date, the PowerShares DB U.S. Dollar Bullish Fund UUP and the CurrencyShares Japanese Yen Trust ETF FXY have each added more than 2%, while the CurrencyShares Euro Trust FXE has lost around 4%. Get currencies data.

The ECB move to push the overnight cost of capital closer to zero has apparently ignited a “wave of euro carry trades,” said Richard Hastings, a macro strategist at Global Hunter Securities. That’s why the euro-yen has “fallen apart.”

“When the ECB overnight rate was higher than the Bank of Japan’s, there was an interest-rate differential that favored the euro especially against the U.S. dollar,” he said. “That’s part of the reason why we saw $1.35-$1.60 in the euro-dollar for a long time.”

But “when the ECB lowered the overnight rate recently, it ended the differential,” he explained. “Since that time, the euro has declined against the yen consistently and somewhat against the U.S. dollar.”

The euro on Wednesday bought $1.2151, down 6% for the year. It bought 94.97 yen, off more than 4% for the year and 6% for the quarter. Read more on currencies.

”The weakening euro — because of lower rates — leads to other trades, thus it turns the euro into a carry trade, and forces the euro much lower for as long as this process is built on a good foundation of bad euro fundamentals,” Hastings said. “The fundamentals are there, so the trade persists.”

Popularity grows

The use of the euro as a funding currency has gathered steam over the last few months, picking up significantly since around April “as markets increasingly looked for lower ECB policy rates and [the trend] was reinforced by the recent policy easing by the ECB,” said Mitul Kotecha, head of global foreign-exchange strategy at Crédit Agricole.

Initially, in the new year, the euro carry trade was not as popular as the carry trade in the U.S. dollar and Japanese yen “because the markets still believed that the euro could possibly get its act together,” said Wojtek Zarzycki, chief investment officer of Optimal Investing.

The two tranches of the European Central Bank’s Long-Term Refinancing Operations had been introduced “and there was a sense of euphoria where the markets rallied in the first quarter,” pulling the U.S. dollar and yen lower as risk currencies and assets climbed, he said.

“As reality set back in, the benefit of holding euros had become diminished,” said Zarzycki. “Since the USD and JPY were currencies that appreciated during periods of risk aversion, it made more sense to use the EUR as a funding currency as there was little fundamental reason to hold the euro and the interest-rate differential was still favorable.”

All in all, not only are investors benefitting from the interest-rate differential between currencies like the euro and Aussie dollar and euro and New Zealand dollar, “but also the depreciation of the euro against these currencies,” he said.

The euro trades around euro-era lows against both the Aussie dollar EURAUD and New Zealand dollar EURNZD.

“Traders are convinced the euro is going much lower,” said Joe Terril, president of money manager Terril Co. in St. Louis.

“If they are correct, they are literally being paid to take the money,” he said. “If they invest in short-term Aussie rates or other developing countries that can be additional profit.”

Risks

The risks of using the euro as a funding currency for carry trades lies in the potential for any surprises as Europe struggles to get a grip on a spreading financial crisis.

“How does a central bank take action to influence rates and [foreign exchange] when Sicily could send Italy into a liquidity crisis, or if Greece truly cannot come up with any new austerity techniques, or if Spain’s regions cannot function without bridge loans?” said Global Hunter Securities’ Hastings.

He referred to the risks of using the euro in a carry trade function as “simple and enormous.”

For now, the actual bottom of the euro based on being favored in carry trade is “extremely difficult to tell,” said Fuest of Landor Fuest, who nonetheless said that a bottom in the euro of $1.15 is “not unreasonable.”

Weakness in the euro and its use in carry trades place upward pressure on other currencies. And since the U.S. is still in what seems to be a weak dollar-policy stance, “it is a negative as our exports will become more expensive and the travel industry can be negatively affected since many European have been taking advantage of our weak dollar,” he said.

For Japan, “the euro carry trade effect means the Bank of Japan’s options are constrained by the risk of further euro declines based on structural problems in the euro zone… which would force the euro lower against the yen even if the [BOJ] acted to weaken the yen,” said Hastings.

Still, Ken Dickson, investment director of currencies at Standard Life Investments, expects the euro to become “an increasingly popular funding currency over the next twelve months.”

“Interest rates can still be cut further and will also stay lower longer,” he said. “Beside the low funding costs, volatility is also falling and the market expects further currency depreciation. These conditions are ideal for funding currencies.”

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