Draghi Makes Euro Favorite for Most-Profitable Carry Trades With Rate Cuts
Tuesday, 24 January 2012 | 00:00
Betting against the euro may be the most profitable trade in the foreign-exchange market as policy efforts to stave off a European recession debases the currency.
Borrowing in euros and investing in the currencies of Australia, Brazil, Mexico, South Africa and South Korea has returned 7.8 percent since the European Central Bank cut its benchmark interest rate on Nov. 3 for the first time in more than two years, according to data compiled by Bloomberg. So- called carry trades funded with yen have lost 0.3 percent and gained 1 percent when financed with dollars.
While a debt crisis entering its third year has driven the region’s shares to the cheapest levels since 2004 compared with the U.S. and the sovereign-bond market posted its biggest rally on record last month, euro bears say the currency won’t rebound anytime soon to wreck carry-trade profits. With government austerity measures threatening growth, ECB President Mario Draghi may have to cut rates to prop up an economy the World Bank expects to contract.
“We’re seeing a very clear breakdown in the correlation between the euro and risky assets,” said Ian Stannard, head of European currency strategy at Morgan Stanley in London. “That highlights the fact that the euro is increasingly becoming a funding currency.”
The median forecast of economists surveyed by Bloomberg is for the ECB’s key rate to fall to 0.75 percent in 2012 from the current record low of 1 percent. Draghi reversed the strategy of his predecessor Jean-Claude Trichet, reducing the rate by 0.25 percentage point in November and again last month.
The 17-nation euro has weakened 4.2 percent in the past three months, the worst performance among 10 currencies tracked by Bloomberg Correlation-Weighted Indexes. The common currency was at $1.2920 at 10:22 a.m. London time, down from last year’s high of $1.4940 in May. It traded at 99.48 yen after sliding to an 11-year low of 97.04 yen on Jan. 16.
Carry trades funded with one million of euros to buy Australia’s dollar, Brazil’s real, Mexico’s peso, South Africa’s rand and South Korea’s won returned 27 percent, or 270,000 euros, during the two years the ECB held the benchmark rate at 1 percent through April 2011, according to Bloomberg data.
The trade lost 2.8 percent as the central bank tightened monetary policy from April to November.
“It’s unlikely that the authorities will move to avoid the softening of the currency, therefore, it becomes a more attractive carry trade,” Tim Riddell, head of global markets research in Singapore at Australia & New Zealand Banking Group Ltd., said of the euro in a Jan. 16 telephone interview. “Other currencies which have effectively low or zero rates, such as the dollar and yen, are facing a slightly better growth profile.”
Spiraling deficits and debt burdens have spurred Greece, Ireland and Portugal to seek bailouts from the European Union and International Monetary Fund. The contagion spread to larger economies last year, driving up yields in the region to an average of 4.28 percent in November, the highest since 2009, even as rates on Treasuries fell to record lows.
The World Bank said this month that the economy in the euro area will probably contract 0.3 percent this year, compared with global growth of 2.5 percent. Leaders, including Draghi and German Chancellor Angela Merkel, will gather in Davos, Switzerland, this week to discuss tackling the crisis without depressing the economy.
For all the concern about Europe, the euro remains higher than its average of $1.2055 since its January 1999 inception. Median analyst estimates compiled by Bloomberg show the currency strengthening this year to $1.29 and 100 yen.
European exporters are benefiting from its depreciation. The weaker currency helps Salvatore Ferragamo SpA (SFR), an Italian maker of handbags and shoes, be more competitive overseas and boosting margins, Chief Executive Officer Michele Norsa said at a Jan. 15 fashion show in Milan.
After Europe’s shares tumbled last year, wiping out 751 billion euros in market value from the Stoxx Europe 600 index, signs of a rebound are emerging. The index is up 3.5 percent this year, and the region’s sovereign bonds have returned 0.6 percent after soaring 4 percent in December, according to the Bank of America Merrill Lynch EMU Direct Government Index. That may cause investors with bets that profit from declines to reverse those trades.
“Short positions have accumulated, and positive headlines are likely to spark an unwinding of these positions in the near term,” said Masashi Murata, a currency strategist in Tokyo at Brown Brothers Harriman & Co.
Futures traders have increased bets to a record that the euro will weaken against the dollar. The difference between wagers that the shared currency would fall versus those that it would rise surged to 160,030 in the week ended Jan. 17, data from the Commodity Futures Trading Commission showed. As recently as August, there were net bets on a euro gain.
At the same time, the cost to protect against a drop in the euro against the dollar is falling, suggesting traders see less scope for decline. Risk-reversal rates for three-month options on the euro versus the dollar shrank to negative 1.7 percent today from as low as negative 4.5 percent in November.
Draghi will still likely take further measures to bolster Europe’s financial system to soften the economic blow from austerity measures. In addition to rate cuts, the ECB decided last month to offer unlimited three-year loans to banks and has purchased sovereign bonds.
Those moves caused its balance-sheet assets to swell to a record 2.74 trillion euros at the end of December, more in dollar terms than the Federal Reserve (FARBAST)’s $2.92 trillion.
“The addition of euros to the market from the ECB tends to weaken the currency,” said Jeremy Hale, head of macro strategy at Citigroup Inc. in London. That “makes it a more attractive carry trade and as a funding currency,” he said.
Citigroup forecasts a rate cut by the ECB in the second quarter. The euro will end the year at $1.20, he said.
The ECB’s easing has helped push yields on German two-year bunds below Treasuries of similar maturity for the first time since mid-2010. They are within eight basis points of Japanese bonds, down from about 170 basis points, or 1.7 percentage points, in May.
“Without a big game-changing development, it is hard to be bullish on the euro,” Sacha Tihanyi, a Hong Kong-based currency strategist at Scotia Capital, the investment banking unit of Bank of Nova Scotia, wrote in a response to an e-mail inquiry on Jan. 16. “Our bank’s view is that the ECB cuts rates to 0.5 percent by the end of first quarter, and under such a scenario, the euro becomes much cheaper to fund with.”