Foreign exchange: Euro to seize carry-trade funding mantle
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Foreign exchange: Euro to seize carry-trade funding mantle

ECB injection lifts risk sentiment; Low-rate prospect boosts appeal

The euro could become the FX market’s carry-trade funding currency of choice, taking over the mantle once held by the yen and, more recently, the dollar. That could be a shot in the arm for asset markets, which have enjoyed a strong start to the year, with the S&P500 putting in its best performance since 1987.

Ahead of the financial crisis, the yen was the main funding vehicle on global markets, with carry-trade investors selling the low-yielding Japanese currency to fund the purchase of riskier, higher-yielding assets elsewhere.

The Funding Currency of Choice?
Relative ECB/Fed Balance Sheet
Source: Reuters Ecowin, Morgan Stanley Research

Substantial deleveraging after the collapse of Lehman Brothers saw the yen surge higher as investors unwound positions. The dollar replaced the yen as the funding currency of choice, with the Federal Reserve’s quantitative-easing programme encouraging investors to use the US currency as a funding vehicle.

However, a recent uptick in US economic data – and, thus, a reduced need for further QE – points to a shift in the preference for a funding currency towards Europe, where the outlook seems much more benign, say analysts.

“Slowly but surely, the euro will convert from being an asset into a liability currency, inheriting this position from the dollar,” says Hans Redeker, head of global FX strategy at Morgan Stanley.

This has largely been driven by the actions of the European Central Bank in flooding the market with liquidity, as it attempts to stabilize the European periphery and the eurozone banking system.

In December, its long-term refinancing operation provided banks with €489.2 billion in cheap funding, while analysts predict February’s operation could meet with a similar uptake.

That has stabilized bank stock prices and reduced liquidity risks. However, it does not necessarily translate into positive sentiment towards the euro, argues Redeker.

Typically speaking, any central bank that seeks to expand its monetary base faster than its peers can expect its currency to depreciate. That might not be a bad thing as far as investors are concerned, considering the new carry trade.

“While the ECB’s liquidity provisions should boost risk appetite once again, we remain convinced increased ECB liquidity will put the euro under further selling pressure,” says Redeker.

Indeed, the ECB’s action has resulted in a change in the behaviour of the euro on the FX markets, with the single currency losing its positive correlation with risky assets.

The shift in the behaviour of the euro can be seen in its new relationship with stocks. The correlation between the euro-dollar rate and the S&P500 stood at 0.8 in May, fell to 0.5 in November and now stands at 0.07. The euro-dollar rate, in other words, now has a zero correlation with equities.

The euro has underperformed most acutely against high-yielding currencies, such as the Australian and New Zealand dollars – classic carry-trade target currencies. Moreover, figures showing that speculators on the Chicago Mercantile Exchange have built up record short positions in the single currency suggest it is being used more and more as a funding vehicle.

Peter von Maydell, global head of FX strategy at Credit Suisse, believes the euro will be the funding currency of choice during 2012, given the prospect for a multi-year period of low ECB interest rates, reduced funding stress and its relatively low volatility.

That latter point is important, since the success of a carry-trade strategy relies not only on rising asset prices but also relative stability in the funding currency. That is because any sudden appreciation in a funding currency can quickly wipe out profits made on the asset side of the trade.

Indeed, euro-based currency pairs have lower volatilities – both historical and implied – than dollar-based pairs across the FX complex.

Von Maydell says that although the euro has become more attractive as a funding currency as the ECB has lowered effective yields in the money markets, the legacy of past dollar weakness and low dollar yields means the weight of money remains overwhelmingly tilted toward dollar-funding across investment styles and asset classes.

However, he expects that to change. “As the relative attractiveness of dollar over euro funding fades due to ECB actions, we expect the euro to depreciate further against the dollar and emerging market currencies,” he says.

Others remain more circumspect over the rise of the euro carry trade and the effect of the ECB’s liquidity operations. Analysts point to the fact that the ECB’s January monthly bulletin showed a strong correlation between banks’ funding needs and the level of participation in December’s three-year auction.

“This suggests that funding carry trades is not the primary motivation for taking cash,” says Simon Smith, chief economist at FXPro. “Banks do and should have more pressing matters on their minds, such as meeting new capital requirements by mid-year.”

How much further that can run would now seem to rest on the outcome of February’s LTRO.

With banks’ funding needs satisfied, a healthy uptake could see asset prices lifted and the euro suffer as the carry trade gets under way in earnest.

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