Market Extra: Euro finds its niche as a funding currency

By Myra P. Saefong, MarketWatch


The euro’s popularity as a funding currency for so-called carry trades has grown.

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.

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Some of the euro’s appeal as a funding currency, however, dulled on Thursday, as the shared currency rallied against the U.S. dollar after ECB chief Mario Draghi said the central bank stands ready to do whatever it takes to save the euro.
Read more in currencies story.

Early Thursday, the euro was buying around $1.2298, up about 1.3% from a day earlier, but still down 5% for the year. It bought 96.14 yen, up 1.4% from Wednesday, though off 3.5% for the year and nearly 5% for the quarter.

“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.

The U.S. dollar and Japanese yen had been instruments for carry trades with 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

/quotes/zigman/4867933/sampled EURUSD

 recently sank to a two-year low and the euro

/quotes/zigman/4868097/sampled EURJPY

 has fallen to its lowest level since 2000 versus the yen. Currency exchange-traded funds have also reflected the move: quarter to date, as of Wednesday, the PowerShares DB U.S. Dollar Bullish Fund

/quotes/zigman/1502728/quotes/nls/uup UUP

 and the CurrencyShares Japanese Yen Trust ETF

/quotes/zigman/453625/quotes/nls/fxy FXY

 have each added more than 2%, while the CurrencyShares Euro Trust

/quotes/zigman/434221/quotes/nls/fxe 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.

“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.”

Popularity grows

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.


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