The fastest convergence in short-term interest rates in almost a year is making the euro a surprise addition to currencies used to finance investments in higher- yielding assets.
“The hot guys are moving into using the euro as a funding currency,” said John Taylor, who helps oversee $7.5 billion as chairman of New York-based FX Concepts LLC, manager of the world’s largest foreign-exchange hedge fund. “It’s not quite as cheap as the yen but it’s a lot safer in a crisis, because the worse the world looks the worse the euro looks.”
Borrowing in euros to finance an investment in the Australian dollar, New Zealand dollar, Brazilian real and Norwegian krone returned 10 percent in the past 6 months, according to data compiled by Bloomberg. The same trade using the dollar instead of the 16-nation currency resulted in a 7.5 percent loss, and a 7.4 percent decline with the yen.
Deteriorating economic prospects in the euro area have helped push down the cost of short-term borrowing in Europe relative to the U.S. The London interbank offered rate, or Libor, for three-month loans in euros fell to within about 14 basis points, or 0.14 percentage point, of the dollar rate on May 21, from 26 basis points at the end of April and 40 on Dec. 31, according to data from the British Bankers’ Association.
Libor for loans in dollars for three months was 0.497 percent at the end of last week, compared with 0.636 percent for euros, the BBA said. The European Central Bank’s main refinancing rate is 1 percent, while the Federal Reserve’s target rate for overnight loans is as low as zero.
Relative Growth
The debt crisis that spread from Greece to euro-member countries including Portugal and Spain prompted the ECB to start measures including buying sovereign bonds as part of a 750 billion-euro ($936 billion) European Union backstop for the 16- nation region.
In contrast, the Fed is winding down programs to revive the U.S. economy. Policy makers lifted their quarterly growth forecast last week, saying gross domestic product may expand 3.2 percent to 3.7 percent this year, up from a range of 2.8 percent to 3.5 percent predicted in January. The euro region may grow 1.1 percent, according the median estimate of 25 economists surveyed by Bloomberg News.
The euro fell 12.9 percent against a basket of peers between last year’s peak in June and May 14, before rebounding 3.4 percent last week on speculation the ECB may be forced to take action and prop up the currency, Bloomberg Correlation- Weighted Currency indexes show. The euro fell 1.3 percent to $1.2411 as of 10:52 a.m. in London, and slipped 1 percent to 111.96 yen.
Euro Forecasts
The shared currency will depreciate to $1.24 by year-end, and $1.22 by the first quarter of 2011, based on the median of no fewer than 40 analyst forecasts compiled by Bloomberg. Estimates are declining at the fastest pace since December 2008. As recently as November the median prediction was $1.48.
“The ECB’s loose-policy stance will extend the euro’s use as a funding currency versus the high-yielders, commodity currencies and emerging-market currencies,” said John Normand, the London-based head of global foreign-exchange strategy at JPMorgan Chase & Co. The bank cut its year-end euro forecast on May 17, to $1.20 from $1.35.
Europe’s fiscal crisis is claiming political casualties, making it harder for policy makers to push through legislation to support the region’s weaker nations and the euro.
German Chancellor Angela Merkel’s party lost control of the nation’s most populous state on May 9, depriving her of a majority in the federal government’s upper house. Voters in North Rhine-Westphalia punished her reversal on providing 22.4 billion euros in aid for Greece, which was approved by the parliament two days before the election.
No Support
Merkel failed to win support from other members of the EU last week when she prohibited naked short selling, where traders bet on a decline in securities they don’t own, sending the euro down to $1.2144, the lowest since April 2006. ECB executive board member Jose Manuel Gonzalez-Paramo said May 20 the central bank wasn’t given warning of the ban by Germany, whose deutsche mark was the basis for the European currency.
“If Germany can’t get its act together and realize what’s at stake, then don’t expect the rest of the euro zone to,” said Geoffrey Yu, a London-based strategist at UBS AG, which cut its year-end forecast for the euro to $1.15 from $1.30 on May 13. “It’s very difficult to have any faith in euro-region policymaking.”
Carry Trades
The yen has been used to fund carry trades as the Bank of Japan maintained the lowest benchmark rateamong the Group of 10 nations for more than a decade in an effort to end deflation.
America’s dollar joined the yen as the Fed cut its target rate for overnight loans between banks to a range of zero to 0.25 percent in December 2008 and the outlook for the greenback worsened. TheDollar Index, which tracks the currency against those of six major trading partners, fell 12 percent in the final 10 months of last year to 77.860, before rebounding 10.6 percent this year to reach 86.132 today.
Selling the yen against the Australian and New Zealand dollars, the real and the krone produced an average annual return of 13 percent between 2000 and 2008, compared with 8.5 percent by selling the U.S. dollar and 3.7 percent with the euro, according to data compiled by Bloomberg.
The strategy of buying currencies in nations with relatively high interest rates such as Australia or Norway with loans in currencies that have low rates has largely been abandoned by investors this year amid increasing volatility. The euro’s decline is reviving interest in the trade.
Implied Volatility
“Using the euro as a funding currency for carry trades is becoming more popular with us at the moment,” said Ken Dickson, a money manager in Edinburgh at Standard Life Investments, which oversees $176 billion.
There is a 45 percent probability the euro will fall to $1.15 by Dec. 31, and a 5 percent chance it will weaken to parity with the dollar, implied volatility from options trading monitored by Bloomberg shows.
Demand for one-month options giving investors the right to sell the euro relative to those that allow for purchases fell from the most since before 2003 last week, the first decline in five weeks.
The biggest risk to returns is volatility, which can wipe out profits should the funding currency appreciate. One-month implied volatility on the euro against the Australian dollar increased to as much as 20 percent last week, from less than 9 percent in March.
Currency Characteristics
“For a funding currency you need low rates, a currency that is depreciating and low volatility,” saidAndreas Hahner, a money manager at Allianz Global Investors in Frankfurt. “The euro has the first two, but there is a danger that when the situation stabilizes the bounce back in the euro might be too high to say yes, it is a funding currency.”
While the euro project has many challenges, it is “ridiculous” to suggest that the euro area will break up within the next year, Goldman Sachs Group Inc. Chief Global Economist Jim O’Neill said in a May 17 interview.
While the euro fell at the fastest pace since January 2009 this month, it is not yet undervalued, according to John Lipsky, first deputy director at the International Monetary Fund. The currency’s current level is close to an “equilibrium” value and its decline against the dollar may help European exports, he said in an interview in Tokyo on May 19.
“It’s perhaps easy to forget the euro, when it was created, debuted at a value of $1.17,” Lipsky said. “The current level of the euro does not appear to pose problems.”
Fair Value
The euro’s fair value against the dollar is $1.20, according to Standard Life’s Dickson. “To give the economy some assistance, the authorities are probably looking for a medium- term period of the currency being undervalued,” he said.
Italian Prime Minister Silvio Berlusconi said May 19 the euro’s slide is good for Europe’s biggest exporters, after Merkel told German lawmakers the currency “is in danger.”
Companies are already starting to benefit. Airbus SAS, the world’s biggest aircraft manufacturer, said May 14 its order book is worth 22 billion euros more than at the start of the year because of the weaker currency.
“Approximately half of our costs are still in euros, whereas all of our revenues are in dollars,” Toulouse, France- based Airbus Chief Operating Officer John Leahy said in a May 19 interview. Every 10 cents that the euro falls against the dollar, “we can improve the operating result by approximately a billion” euros, he said.
Heading Lower
The euro is still heading lower, said Allianz Global’s Hahner, citing the likelihood that the Fed will raise rates before the ECB.
U.S. central bankers will lift their target rate to 0.5 percent by year-end, while the ECB holds pat, according to medians of at least 20 economist forecasts compiled by Bloomberg.
Plus, the French and German electorates’ support for the euro in the face of rising costs for holding the 11-year old currency project together has yet to be tested, FX Concepts’ Taylor said.
“We’ll be listening to the political broadcasts from Madrid, Lisbon, Athens and Paris for quite a while to see if they throw these guys out,” said Taylor. “The euro’s going down. It has a very bleak future.”
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