Euro transforms from risk proxy to funding currency

The path of the euro was closely correlated with risky assets during most of the second half of 2011, but that started to change towards the end of the year. The change was exacerbated by the European Central Bank’s decision last month to extend cheap three-year funding to European banks through its LTRO, resulting in the euro underperforming most acutely against high-beta currencies such as the Australian and New Zealand dollars, rather than the US dollar.

The change in the behaviour of the euro can also be seen in its new relationship with stocks. The correlation between EURUSD and the S&P 500 stood at 0.8 in May, fell to 0.46 in November and currently stands at 0.07. EURUSD, in other words, now has zero correlation with equities.

Indeed, the euro has failed to benefit from the recent rebound in risk appetite, caused in part by the ECB’s action to lower the funding risks in the European banking system, but also by signs of resilience in the US economy.

Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi UFJ, says the change in the performance can be mainly attributed to the negative impact of looser ECB monetary policy, but also to the actions of global reserve managers.

Hardman says the euro normally benefits from a pick-up in risk sentiment, as it usually corresponds with rising foreign-exchange reserve accumulation, which generates euro supportive diversification flows.

“However, with domestic currencies of most major FX reserve holders still weakening, it is likely that reserve accumulation remains modest, if not still declining, as domestic authorities – especially in Asia – have been intervening to dampen domestic currency weakness,” he says.

Some argue that the euro is set to usurp the dollar and become the funding currency of choice, and thus start to display a negative correlation with risky assets such as equities and higher-yielding currencies.

Morgan Stanley recommends investing in high-beta currencies and using the euro as a funding currency, predicting an acceleration in losses for EURAUD, EURNZD and EURCAD in the coming weeks.

Hans Redeker, head of global FX strategy at Morgan Stanley, says investors are sitting on a pile of cash, and with inflation exceeding yield returns, the opportunity cost of holding such elevated stockpiles is high.

“In this environment, it does not take a lot to create a bullish environment for assets,” he says.

“We put our money on a significant bear market rally, but unlike previous occasions, we fund our positions in high-beta currencies with the euro and not the dollar.”