A devaluation of the Chinese yuan and a sell-off in emerging market currencies is making investors re-evaluate whether they should still borrow euros at low interest rates and invest them in other assets for higher returns.
Since China's 2 percent devaluation of the yuan on Tuesday, the trade-weighted euro basket has soared to its highest in eight weeks. That will worry the European Central Bank, which has been trying to support growth and boost inflation by flooding the system with cheap euros.
Traders said the euro's outperformance against the dollar and other major liquid currencies this week was helped by an unwinding of so-called carry trades, in which investors sell a lower-yielding currency like the euro to buy a higher-yielding one like the yuan, or other emerging market currencies and riskier assets like stocks.
The euro hit a one-month high of $1.1215 on Wednesday, up 1.2 percent for the week and well above a decade low of $1.0457 struck in March.
"Euro-funded carry trades, especially those investments into Asia, have been extremely popular in the past year," said Alvin Tan, currency strategist at Societe Generale.
"These short euro/long emerging market positions are being unwound. And we think, if the Chinese yuan were to weaken further, then the euro will gain even further."
The yuan dropped to a four-year low after Tuesday's devaluation, as slowing exports from the world's second-largest economy sparked fears about global growth and disinflation. Other Asian currencies also hit multi-year lows.
Tan said that over the 12 months to the start of August, trades where investors borrowed euros to invest in high-yielding Asian emerging market currencies had returned 6 to 7 percent.
Those returns now appear at risk. Many emerging market currencies are likely to weaken further as their central banks try to gain a competitive edge for their country's exports. And with the Federal Reserve set to raise US interest rates - perhaps next month - they may face more selling pressure.
Carry trades work best when investors borrow in a cheap and liquid currency that is either stable or gradually declining. However, in an uncertain economic climate and upheavals in financial markets, these trades can take a hit.
EURO HEDGES, FED WATCH
Analysts said the euro's rise was also caused by investors unwinding hedges put in place to guard against its weakening, including against emerging market currencies.
Foreign investors buying European stocks and those borrowing in the euro to re-invest have had to hedge their currency exposure. Analysts said with the euro rising, some were being driven to trim those hedges.
According to the Bank of International Settlements, global cross-border lending - a snapshot of cumulative foreign- investor exposure to the euro zone - surged $406 billion to euro zone countries in the first quarter, the highest quarterly rise since early 2008.
"We are in a situation where people are taking off short euro hedges, which explains why the euro is being so resilient," said Manik Narain, emerging market currency strategist at UBS.
"For most of 2014 and in the first quarter of 2015, euro versus emerging market FX was in a large downtrend, so a lot of investors tried to hedge their forex risk by selling euro, because that way they didn't have to incur the carry cost of selling emerging currency."
Narain said that in April a basket of the euro against 20 emerging market currencies and tracked by UBS was down 9.5 percent since start of 2015. Now, it is down barely 1 percent, highlighting how much the euro has recovered.
The yuan devaluation triggered fresh fears of "currency wars", in which countries devalue to make their exports more competitive. It has also led some investors to question the timing of the Federal Reserve's long-awaited increase in interest rates, which would tend to push the dollar higher.
"If there is a fresh currency war in the Asian region, the upward trend in the United States' effective exchange rate will likely find new momentum," said Jane Foley, senior currency strategist at Rabobank.
Comments
Comments are closed.