Friday 19 January 2018

Euro is gaining 'safe-haven' status among traders at worst time for Draghi

Further strengthening of the Euro's exchange rate could curb exports and cap inflation
Further strengthening of the Euro's exchange rate could curb exports and cap inflation

Anchalee Worrachate

The "Japanification" of the euro is all but complete.That's the message from the foreign-exchange market, where - just like the yen - the euro now tends to strengthen when investors need havens.

The two currencies' fluctuations versus the dollar are the most alike since the 2007 financial crisis. It's a reflection of how, even with the challenges faced by both economies - from stagnant growth to an aging population - their strong trade positions mean they don't need to rely on foreign capital to finance deficits.

That's allowed the euro to defy many of the market's best and brightest, who've been calling for it to weaken to parity versus the greenback.

"The euro has behaved like the yen, and recently more so," said Ulrich Leuchtmann, head of foreign-exchange strategy in Frankfurt at Commerzbank, which topped the Euromoney Institutional Investor currency research rankings for 2015.

"The policy challenge for the ECB is that the currency appreciation may come at the moment when they least want it - when it's totally out of line with the economy."

The trend was illustrated last week by the currencies' reaction to a key Chinese manufacturing gauge, whose slump to a six-and-a-half-year low sparked a sell-off in Asian stocks. The euro posted the biggest gain among major peers versus the dollar, while the yen briefly climbed to the highest level last week.

"The euro is looking like the yen - where money tends to come home when the world is a scary place," said Kit Juckes, a strategist at Societe Generale SA in London. "The ECB wouldn't want to see the euro strengthen much from here, and the danger is that it might if we see renewed risk aversion."

A stronger exchange rate has the potential to curb exports and cap inflation, which dents demand. Bank officials, led by ECB president Mario Draghi, have projected that consumer prices will barely rise this year and might even fall.

Japan and the eurozone also share surpluses in their current accounts, the broadest measure of trade, which make their currencies less vulnerable to capital outflows - and popular with investors fleeing risk. And they both have near-zero interest rates and a bias for their central banks to provide more stimulus.

These similarities have allowed the euro to take on one of the yen's traditional roles: funding carry trades, where investors borrow cheaply in one currency to purchase a higher-yielding asset elsewhere. Unwinding the deals amid the turmoil in emerging markets involves buying back Europe's single currency, which has provided support.

This trend - what SocGen's Juckes calls the "Japanification" of Europe - showed up in the government bond market first, where yields started falling to records (and approaching the lows seen in Japan) as far back as 2012.

From more than two percentage points higher than their Asian-nation peers at the start of this decade, the difference is now less than half a percentage point, according to data from Bank of America Merrill Lynch.

Europe's single currency has arrested the slide that saw it lose a fifth of its value from the middle of 2014 through March. It reached a seven-month high of $1.1714 in late August, as concern over China's economic woes were deepening and sending global stocks tumbling.

With the yen recovering from the 13-year low that it reached in June, the 120-day correlation between the currencies against the dollar has climbed to 0.6, the highest since the start of 2007. (A figure of 1 would mean they're moving in lockstep.)

Despite the euro's recent strength, SocGen is one of a shrinking number of banks that still sees the shared currency falling to parity with the dollar - predicting that level by the end of the first quarter of 2016. Commerzbank forecasts a drop to $1.05 in that period, about level with the median estimate in data compiled by Bloomberg.

Andreas Koenig, of Pioneer Investments, acknowledges the similarities between the euro and yen, however, he questions whether they'll last.

"The euro isn't a haven, but is acting like one because of its role in the carry trade," according to Koenig. "The distinction is important," he said, "because it means the link between the euro and riskier assets will diminish as these positions, or shorts, are unwound.

"We see the euro as a funding currency rather than a haven currency which investors turn to for safety," said Koenig.

"It's just cheap to short the euro. People have lightened up those positions during the recent period of risk-off. The more that happens, the weaker the correlation will become."


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