Is the euro the new funding currency?

By Brenda Kelly - Chief Market Strategist at IG

Date: Tuesday 22 Apr 2014

Is the euro the new funding currency?

Recent strength in the euro against other major global currencies is compounding the declining inflation trend in the single currency area and has in ways encouraged investors to pile into the riskier bond markets of the peripheral countries.

Even Greece, which recently had to restructure its debt, has been able to tap the market at very low yields. Concerns about low inflation may cause the ECB to take further action down the road.

The strength of the euro has already had a negative impact on European corporate earnings for the first quarter. Thus, the weak start to the earnings season has its basis on the oft-cited and recurring theme of adverse currency movements.

As the global economy regains its footing, it brings with it the gradual reversal of loose monetary policy by the US and other large economies.

This change in policy tack has certainly served to reveal how fickle capital flows can be.

The Federal Reserve, on a program of loose policy and quantitative easing, has kept interest rates near zero since 2007, prompting investors to seek yield elsewhere – mainly emerging economy bonds and equities.

Hints from the Federal Open Markets Committee (FOMC) back in May 2013, that it would start tapering its $85bn-per-month bond-buying program stoked the fires of volatility in emerging markets and ergo their currencies – the reaction in the markets was swift.

Once considered the engines of growth during the height of the downturn, the currencies of the ‘fragile five’: Brazil, India, Turkey, South Africa and Indonesia were subjected to a sharp decline.

A brief respite in the sell-off came when the Fed decided to postpone the taper back in October only to return with a vengeance in the early part of 2014, when it became clear that the Fed was changing its easy liquidity trajectory.

In January 2014, the Turkish lira plunged to a record low against the dollar, the Thai baht had lost half its value in six months and the Argentine peso underwent its steepest decline since its (most recent) financial crisis in 2002, forcing the central bank to relax capital controls in order to stabilize the currency.

Turkish policy makers lifted their benchmark interest rate to 10% from 4.5% at a January 28th emergency meeting.

Considering parallels with the 1990s crisis were drawn only a couple of months ago in respect of the emerging markets currency declines, there has been a rebound in these currencies since the end of February.

As we enter a post-taper world and anticipate tightening in monetary policy going forward, one must ask whether this rebound is a temporary bounce or simply marking the beginning of the ‘carry trade', the strategy of borrowing in low yielding currencies to buy assets that yield a higher rate again.

Moreover, will the euro prove to be the main currency that is borrowed in order to fund the buying assets that yield a higher rate?

In March, the FOMC once again elected to reduce the monthly pace of its quantitative easing program by another $10bn and scrap the 6.5% unemployment rate threshold that previously characterized its 'forward guidance' on the likely future path of short-term interest rates, as was largely expected.

It also lowered its GDP and unemployment rate forecasts, but brought forward its projections on the likely timing of rate hikes.

Fed head Janet Yellen’s comments from her first press conference set the veritable cat amongst the pigeons; when asked to clarify what a ‘considerable time after the asset purchases program ends’ meant – her response was ‘somewhere on the order of six months depending on conditions at that time’.

Markets chose to focus on the first part of the reply, sparking a sell-off in the stock market and pushing yields on US Treasuries higher.

Much reneging on this hawkish statement has been attempted since by various members of the Fed and reassurances that bond buying would be required for some time has helped to support emerging market currencies. Thus, we may now be seeing the first insurgences of the carry trade.

Likewise, the ECB has begun to look at the exchange rates - which marks a change from the norm - and ultimately is doing its best to talk the currency down.

As it stands, the euro is trading at a pivotal zone. When examining recent trading flows it would seem that the large FX traders are not yet anticipating a decline so positions' directions have not ramped up to reflect the potential downside in the euro.

If confidence in the Eurozone is returning, volatility in emerging markets stabilizing and if the ECB decides to cut interest rates further or indeed embark on a more aggressive stimulus plan in a bid to counter ‘lowflation’ levels, then we may well see long-term investors begin to fund positions in euros on expectations that imminent lower interest rates will make it cheaper to borrow the currency.

The Draghi rhetoric may require some supporting action - it may be in the offing.

Brenda Kelly is Chief Market Strategist at IG

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