Euro carry trade the new 'Bernanke put'
As the Fed prepares for rate hikes, the hope is that the ECB stands ready to take over its mantle as chief global liquidity provider, raising the spectre of the euro becoming a more attractive funding currency for carry strategies.
European Central Bank (ECB) governor Mario Draghi’s recent package of measures – including an asset-backed securities (ABS) and covered bond purchasing programme and a 10 basis point euro rate cut – for reviving the eurozone economy, gripped by deflation fears, increases the currency’s attractiveness as a funding currency if the Fed continues to tighten monetary policy, say analysts.
Investors can borrow ever-cheap euros to fund investments in higher-yielding currencies.
“The euro-funded carry trade is the new Bernanke put,” says Valentin Marinov, head of European G10 FX strategy at Citi. “Euros could join the yen as one of the most attractive funding currencies,” potentially attracting new European investors to the carry trade.
|Now it looks like we have the Fed and the BoE
in one camp and the ECB and BoJ on the other
European traders wanting to buy emerging market (EM) currencies will feel emboldened to pay with their home currency, where they might previously have used dollars or yen. What’s more, the euro is proving an attractive funding currency for long positions in the Turkish lira or South African rand, regardless of investors’ home currency.
“These euro crosses are more actively traded than their respective dollar or yen counterparts,” says Marinov.
Neil Staines, head of trading at ECU Group, an investment firm specializing in currency management, adds: “The dollar is predominantly the base for EM currency trades and, over recent years, its low rates have fostered USD-denominated carry trades.”
However, as US rates rise, euros, yen and Swiss francs will likely replace the USD as funding currencies, he says.
Exactly how much of this is down to Draghi’s recent actions is debatable.
“There is a case to be funding carry trades with euros, but the recent cut in interest rates and the lower longer-term rates, targeted through the new ABS programme, are not necessarily the drivers for it,” says Staines.
“It is more about a negative economic and political outlook for the eurozone, and economic and monetary divergence with the US.”
There are also factors counting against the carry trade in the current market.
“The potential benefits of increasingly favourable interest-rate differentials are offset by increasing volatility,” says Staines. “G7 volatility is now above EM currency volatility for the first time since October 2013, largely as a result of the diverging monetary policies of the US and UK to those of the eurozone and Japan.”
Not a deterrent
However, this does not appear to be deterring some investors.
“We have seen inflows into our FTSE FRB10 Index Fund [forward rate bias fund, investing in G10 currency pairs to exploit interest-rate differentials] as investors have recognized increasing divergence in central-bank policy is creating better prospects for carry strategies,” says James Wood-Collins, CEO at systematic currency fund manager Record Currency Management.
There has always been an attractive carry available between G10 and EM currencies, given the gulf in rates, but recent macroeconomic shifts have reinforced its allure, if with a smaller pay-off, pairing G10 currencies. If, as expected, US rates start to increase next year, more traders will sell euros or yen to buy US dollars.
“We are entering a more divergent world,” says Wood-Collins. “We had a single global policy imperative steering the Fed, the ECB, the Bank of Japan (BoJ) and the Bank of England (BoE), meaning low rates and widespread liquidity everywhere.
“Now it looks like we have the Fed and the BoE in one camp and the ECB and BoJ on the other. Central banks are acting according to their own domestic policy objectives and it is that change that encourages interest in the carry trade.”
If eurozone yields do continue to fall, Marinov says “that should make Europeans more likely to export their excess savings, the current-account surplus, abroad, much like the Japanese have been doing in the last 20 years”.
The interest paid on eurozone bank deposits held at the ECB is now minus 20bp, compared with plus 25bp for the equivalent rate (interest on excess reserves) at the Fed. Hence, where it is possible from a capital and regulatory perspective, switching reserves from euros into dollars offers a 45bp carry.
The incentive to look at carry strategies might also increase in coming weeks for banks in particular.
“European banks have been reluctant to take on any extra risk on their balance sheets ahead of the asset quality review,” says Marinov. “This could change after the results from the bank stress-tests are released on October 18.”
Many carry strategies select currency pairs to glean the widest possible interest-rate differential. With two G10 currencies, the Swiss franc and yen, offering lower rates, the euro is not yet the most attractive funding currency for traders looking for a concentrated position, though it is likely to feature in a diversified carry position.
However, as well as harvesting the interest-rate differential between two currencies, carry traders hope to benefit from favourable moves in the spot prices of the currencies paired.
The strongest argument for funding with euros, other than for diversification, is the belief the currency will decline more than the alternatives, whether because of a future ECB quantitative-easing programme, or as traders digest the implications of the existing programme. Discretionary managers might anticipate bigger moves to come and put on euro shorts early, to avoid missing any big downward moves.
For systematic managers, the euro is unlikely to look more appealing than the Swiss franc or yen at this stage.
“We were short the euro anyway and the marginal changes Draghi announced had no impact on that position,” says Record’s Wood-Collins. “But the ECB does look like it’s on a loosening path, which means more radical measures are possible.”