The US Federal Reserve has pumped trillion of dollars into the US economy since the global financial crisis by buying securities such as government bonds, but will wind up its asset purchase programme this month.
The central bank released a statement yesterday that it was ending the programme because it was confident of a continuing US economic recovery, despite a global slowdown, citing “solid job gains and a lower unemployment rate”.
The decision was widely anticipated but the relative hawkishness of the statement has led many to believe that the Fed will increase interest rates earlier than expected, triggering a surge in the dollar against the euro.
“[There is a] clear shift towards more hawkishness… [this] provides the catalyst for dollar momentum,” says Vasileios Gkionakis, head of global FX strategy at UniCredit.
The euro/US dollar currency pair fell from a high yesterday of 1.27 to as low as 1.25 after the announcement, and analysts predict further euro weakness.
The euro might even hit parity with the dollar, according to analysts at leading banks including Goldman Sachs, Morgan Stanley and Barclays. This would suggest the euro could become a leading funding currency for carry trades, enabling investors to borrow cheaply in euros and invest in higher-yielding currencies, typically emerging market currencies.
“The euro been used as a funding currency for quite some time now; I think people will keep using euro as the currency [goes] lower,” says Gkionakis,
UniCredit predicts further weakness in the euro, with a year-end euro/dollar forecast of 1.22. But despite the euro’s decline and apparent attractiveness as a funding currency, it pales in comparison to the yen.
The yen has substantially weakened against the dollar this year – dollar/yen traded as high as 109 today, compared with 98 a year ago.
“If looking for a true funding currency, we prefer the yen to the euro.” says Adam Myers, head of FX strategy at Crédit Agricole. “The Bank of Japan is more likely to do sovereign QE than the ECB. It is more likely the yen will be used as a funding currency.”
Corporates are preparing themselves for further weakness in the euro and anticipating how this might affect their bottom lines in 2015.
“That [euro/dollar] move overnight after the Fed announcement will prompt a lot of corporates to lift their hedge ratios on EUR/USD,” says Myers. “If it hadn’t fallen overnight I think a lot of corporates would have been inclined to maintain their currency hedging ratios in the 2015 hedging meetings they are having now, as the euro has remained relatively strong over the last three years.”
He adds: “But with the fall I think a few will come out to protect their P&L in 2015.”
However, a weaker euro is a boon for exporters in the eurozone. Ignacio Sanchez Miret, global treasurer and risk manager at international shopfitter HMY Group, says the company had anticipated euro weakness and worked on a few strategies over the past few months to boost its competitiveness.
He says: “We have changed some of our Chinese suppliers' contracts into euros and offshore renminbi and fixed some rates for the whole of 2015 with some of our foreign customers with annual agreements, concentrating as much as possible on the use of the euros in our commercial flows.
“The weakness of the euro currency has to be seen as a good opportunity to sell abroad for our teams and our treasury department is focusing to reduce the bad impact of the currency’s life,” he says.
Analysts are divided as to whether the euro will sink so low as to hit parity with the dollar. Myers points out that the euro remained conspicuously strong throughout the eurozone crisis, largely because central banks continued to diversify their dollar reserves into euros, which artificially supported the currency. “Now that QE is ending, that force has considerably lessened, but it is still a force in 2015 and one of the reasons EUR/USD won’t drop [to parity],” he says.
Myers remains long on the euro, arguing that investors are too optimistic about the Fed tightening monetary policy and will be proved wrong in the coming weeks.
Despite his contrarian view, it remains clear that US and European monetary policies are increasingly divergent, which will put pressure on the euro.