Euro Turns Carry Traders’ Favorite in Worst Year Since 2003

Euro Turns Carry Traders’ Favorite in Worst Year Since 2003
A depreciating euro may soften the region’s recession as goods of member nations become more attractive. Photographer: Kostas Tsironis/Bloomberg

The euro’s strength against the U.S. dollar in the face of the region’s three-year banking and sovereign-debt crisis masks a nine-year low against other currencies, suggesting more weakness to come.

The 17-nation currency is at the lowest level since 2003 on a trade-weighted basis, according to a Deutsche Bank AG index that includes the yen, pound and Swiss franc. The European Central Bank’s July 5 reduction of its deposit rate to zero spurred investors to borrow euros to buy higher-yielding assets elsewhere, generating gains from the carry-trade for the first time in two years.

Even though the euro has slumped 24 percent from a high of $1.6038 in July 2008 as the debt crisis threatens to push the region into recession for a second time in three years, the drop is only about half the collapse versus Australia’s dollar. At the same time, the euro’s depreciation following ECB President Mario Draghi’s rate cuts is making exports more competitive and damping concern that the currency union will break up.

“The euro has now joined the ranks of the funding currencies,” Ian Stannard, head of European currency strategy at Morgan Stanley in London, said in a July 20 telephone interview. “As far as safe havens are concerned, you can easily come to the conclusion that there are better alternatives to holding core European assets, which have negative yields, so you could see an outflow from Europe developing and the euro coming under broad pressure.”

Lower Volatility

Buying the Canadian and Australian dollars and the Colombian peso funded by the euro returned 11.3 percent this year, according to data compiled by Bloomberg. The same trade funded by the dollar gained 4.6 percent.

The carry trade returned 3.9 percent this year, reversing a 15 percent loss last year and 2.5 percent decline in 2010, the UBS AG V24 Carry Index shows. The index rose 13.9 percent in 2009. A decline in exchange-rate fluctuations this year helped lift the allure of these wagers, as lower volatility reduces the probability that changes in currency values will erode gains.

A JPMorgan Chase & Co. option index measuring swings in global currencies ended last week at 8.66 percent, after reaching 8.57 percent on July 19, which was the least since November 2007. Implied volatility, which the bank’s option index tracks and is used in models to set option prices, averaged 10.8 percent since 2000.

Euro Tumbles

European policy makers received a vote of no-confidence in their efforts to stem economic turmoil last week as the euro fell to its lowest in more than two years against the dollar following final approval for a bailout of Spanish banks.

The euro extended last week’s decline today, falling as much as 0.7 percent to $1.2067, the least since June 2010, and less than the lifetime average of $1.2087. It traded at $1.2136 at 12:51 p.m. New York time, down 0.2 percent. Its record low of 82.3 cents was set in 2000. The shared currency weakened to a more than 11-year low of 94.24 yen, while reaching all-time lows of 1.16707 versus the Aussie and 1.5156 against New Zealand’s so-called kiwi.

“If the current set of market conditions continue, further euro underperformance is very likely,” Andrew Cox, a currency strategist at Citigroup Inc. in New York, said in a July 16 interview. Citigroup sees the euro weakening to $1.15 in six months. The median of 52 estimates compiled by Bloomberg is for it to finish the year at $1.23.

Euro’s Fix

A depreciating euro may soften the region’s recession as goods of member nations become more attractive. Sales outside the euro area account for about 60 percent of German exports, about 50 percent for France and around 42 percent for Spain, based on 2010 data compiled Citigroup.

A “much weaker euro” is the only way to avoid a breakup of the bloc, David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York and a former International Monetary Fund economist, said in a July 13 interview. A 20 percent drop versus the greenback would reduce by almost half Italy’s loss of competitiveness since joining the euro, Woo estimates. “It’s very clear that a weaker euro will save the euro in the end.”

Currency options show the risk of a deeper slide in the euro has declined since European policy makers agreed last month to relax conditions on emergency loans for Spanish banks and opened the way to recapitalizing lenders directly with bailout funds. European finance ministers gave full approval on July 20 to an aid package of as much as 100 billion euros ($121 billion) for Spain’s banks.

Butterfly Options

Demand for options hedges against extreme moves in the euro, known as the butterfly, fell this month to a 16-month low. While the 25-delta risk reversal on one-year options has a 2.1 percentage point premium for puts, which grant the right to sell the euro, over calls, which allow for purchases. The premium was almost double that in May.

The one- and three-month euro interbank interest rate fell below their counterparts denominated in dollars this month for the first time since January 2008. While yields on two-year German, Austrian, Finnish and Dutch debt dropped below zero amid the ECB rate cut and as investors are sought investments that would assure a return of their principal.

The difference between interest rates in the euro region and the seven highest-yielding emerging market currencies, including the Russian ruble and Polish zloty, is approaching the widest since at least 2005 after adjusted for volatility, according to data compiled by Bloomberg.

‘Go-Ahead Signal’

As well as cutting the central bank’s main refinancing rate to an all-time low, Draghi reduced its deposit rate to zero to encourage banks to lend to other institutions, companies or households instead of parking excess cash in the ECB’s overnight deposit facility. About 800 billion euros is on deposit with the ECB every day.

“The deposit-rate cut is a go-ahead signal,” Adnan Akant, a managing director at Fischer Francis Trees & Watts Inc. in New York who helps manage $56 billion, said in a telephone interview on July 18. Selling the euro is attractive against purchases of emerging market high-yielding currencies such as the Turkish lira, Australian and New Zealand dollars, Akant said.

The benchmark rate in Australia is 3.5 percent, compared to the ECB’s 0.75 percent main refinancing rate. In New Zealand, whose dollar has gained about 10 percent versus the euro this year, the central bank rate is 2.5 percent. The U.S. has kept its overnight lending rate in a range of zero to 0.25 percent since December 2008.

Risk Appetite

The euro plunged 6.9 percent versus the Australian dollar this year, and has lost more than half of its value from its high of 2.11355 in October 2008.

A deteriorating global economy may hurt the carry trade, said Gavin Stacey, the Sydney-based chief rate strategist at Barclays Plc.

“When risk appetite is falling, as it is at the moment, the carry trade doesn’t seem to be supportive of the currencies like the Australian dollar,” Stacey said in an interview. “The carry trade tends to perform well when risk appetite is improving.”

The euro zone economy will contract 0.3 percent this year, after growing 1.5 percent in 2011, the IMF in Washington said on July 16. Canada will expand 2.1 percent, while Russia is set to grow 4 percent. China’s economy grew 7.6 percent last quarter, the slowest pace since the depths of the global financial crisis in 2009.

Steps this month by central banks to ease monetary conditions buoyed speculation that global growth would persist.

Monetary Moves

The People’s Bank of China joined the ECB on July 5 in cutting its benchmark rate, while the Bank of England raised the size of its asset-purchases. Two weeks earlier, the Federal Reserve expanded a program lengthening the maturity of bonds it holds and Chairman Ben S. Bernanke indicated more measures will be taken if needed.

Standard Chartered Plc this month purchased emerging market currencies using euros for its FX Real Money Portfolio, which is backed by the bank’s own capital and mirrors its strategists’ forecasts. It’s also betting on declines in China’s renminbi.

“With the ECB cutting its deposit rate to zero, the euro is now the funding currency of choice,” Callum Henderson, the global head of currency research at Standard Chartered in Singapore, said during an interview on July 17. “European fundamentals are woeful and continuing to worsen. The ECB has taken bold and aggressive policy action, but cannot do this alone. Real structural reform is needed.”

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