The euro already faces a sea of troubles. But last week’s big currency swings suggest it has another problem that could dash hopes of a recovery: It’s now in the thrall of one of the riskier investment strategies in the currency market – the “carry trade.”
Analysts are now speculating about the euro’s role in the carry trade, which involves borrowing money in countries such as Japan where interest rates are low, then investing it where rates are higher and pocketing the difference. The trade, popular during the credit boom, effectively lowers the value of the currency that is borrowed – i.e., sold – and turbo-charges any currencies that are purchased.
To be sure, investors aren’t doing carry trades like they did before the crisis, when calm markets allowed hedge funds to make massive bets with borrowed money on relatively small differences in expected interest rates. In essence, today’s “carry trades” are just bets on the global economic recovery: You invest in Australia or Brazil, say, and finance yourself as cheaply as possible, which might mean borrowing in euros.
It’s also hard to find actual data proving that investors are doing carry trades or using specific currencies. Analysts made similar gesticulations about the U.K. pound a few months ago.
But last week’s gyrations in the euro’s exchange rate with the Australian dollar – a currency riding high on the country’s link to fast-growing China – provides some evidence that investors are indeed using euros to finance their bets. That is important because it means there may be structural reasons in the investment world why any lift in the euro will simply be quashed.
“One of the most popular trades in (currency) markets since early 2009 has been to sell the euro versus commodity (currencies), for example, the Australian dollar and New Zealand dollar,” analysts at Dutch bank ING Groep NV said in a note Monday. “Last week saw an abrupt reversal of this trend.”
The euro ended up jumping some 8% against the Australian dollar at some point as investors closed out these trades, which meant buying the euro again and selling the currencies they bet on.
On Monday, the euro is slumping again against the dollar, sinking nearly 1% to $1.2418, possibly ending the massive rally from a four-year low of $1.2142 to the $1.2572 we saw at the end of last week. Any enthusiasm about the euro is being overwhelmed by a stronger bearishness. Worse, the euro is possibly now just a marionette controlled by carry traders.
“The euro is the clear-cut funding currency of choice,” said Alan Ruskin, currency analyst at Royal Bank of Scotland, in a report earlier this month.
Why borrow in euros? Mr. Ruskin and other analysts offer several reasons that add up to the likelihood that interest rates in the euro zone will stay low.
Europe’s economic growth remains sluggish and will likely lag that of Britain and the U.S. next year. Europe’s debt crisis and efforts to pare back debts via austerity measures will also limit growth. As a result, the European Central Bank, which handles monetary policy for the 16-member euro zone, may keep rates lower for longer.
Inflation in Europe, meanwhile, remains very low, which suggests the ECB won’t necessarily be under pressure to raise rates anyway.
Making things worse, the ECB’s decision to start buying government bonds of euro zone countries to prop up their funding efforts has worsened widespread doubts about the future of the euro zone itself.
This is why many analysts are now bearish about the euro, with French bank BNP Paribas – the gloomiest of the bunch – betting the euro will reach parity and even beyond against the dollar in early 2011.
The euro may end up having a little more muscle than that given the impressive resilience it’s already shown: The euro isn’t actually that much lower than the $1.50 level it hit late last year. For years, many analysts and European politicians have seen such levels as the currency getting too big for its britches.
But even if newspapers start printing good news about Europe, it could be that the carry trade keeps the euro in its place for months – and maybe years – to come.
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