It’s too early to call an end to the euro’s rout, even after its worst start to a year since 2015.
Money managers from Aberdeen Asset Management to Pinebridge Investments expect more weakness in the common currency. That’s because the factors that pushed the euro to a 34-month low against the dollar, such as carry trades, are still intact.
Even after concerns surrounding the coronavirus subside and the full economic impact of the epidemic on China is priced in, the euro may still struggle to overcome the desire for yield and the dollar’s haven appeal.
It’s also evident in the options market where traders are entering bearish bets. One-month euro puts over calls are seeing the most demand since September, with some traders saying it’s likely the currency will drop below $1.07.
The euro weakened 0.1% to 1.0794 dollars in London.
“The problem with long euro positions is that you need it work for you quite a bit before it starts to make money, because of the negative carry,” said Kieran Curtis, the London-based director of investment at Aberdeen. “I am pretty confident there’s little catalyst for immediate turnaround.”
The European Central Bank’s negative rates and its purchase of corporate bonds in the domestic market have forced European investors to look for positive returns either via euro-denominated bonds issued by emerging-market borrowers or in dollar-denominated assets.
With the sovereign-yield differential between the US and Germany at almost 2 percentage points, that demand is unlikely to fade anytime soon.
Forex researchers at Barclays Plc agree.
“USD strength appears to be driving a ‘dam break’ in EURUSD,” strategists including Marvin Barth wrote in a note. “Our view (is) that global convergence would not occur and that the US would offer a persistent, risk-adjusted, relative return advantage.”
For dollar-based investors, it’s an opportunity to kill two birds with one stone. If they buy an emerging-market bond denominated in euros, they not only get positive yields but when they hedge their euro exposure, they get paid again.
That’s because the currency-forwards market is dictated by the interest-rate differential: the gap between euro and dollar borrowing costs means a short euro position helps capture that difference.
“When you hedge your euro exposure using, say, the three-month rate, the other party is going to pay you,” said Curtis. “Once you add that yield, you are getting a higher return in dollar, net of the hedge.”
And this dynamic is unlikely to change. The relative policy approaches of the ECB and the Federal Reserve seem to have stabilised for at least the next 12 months. Neither is likely to raise rates, according to traders’ bets.
“As the bar for material Fed easing is high, the dollar should keep its interest-rate advantage versus the euro,” said Petr Krpata, the chief currency and interest-rate strategist for the Europe, Middle East and Africa region at ING Group NV.
The foreign-exchange market is increasingly driven by the strength of cross-border flows rather than fundamentals such as valuations and surprises in economic data, BofA Global Research strategists Kamal Sharma and Myria Kyriacou wrote in a note.
“US ‘reverse Yankee’ issuance and Japanese investors selling European assets in favour of US have been a strong focus for investors in recent months,” they wrote.
“With central banks showing little intent to move policy back to a normal footing, the flow of funds channel will likely continue to dominate, in turn lessening the focus on valuation misalignments.”
However, UBS Group AG says the long-dollar trade has become too risky for euro-based investors. The coming decline in the US currency will exceed the yield advantage, Mark Haefele, the Swiss bank’s global chief investment officer, said in a note this week.
He sees the US’s growth advantage over Europe narrowing, and expects the eurozone economy to accelerate this year as companies replenish inventories amid robust domestic demand and a pick-up in global trade.
But with the coronavirus threat still unfolding, the full impact on China’s economy has yet to be factored into market prices, said Anders Faergemann, a senior portfolio manager at Pinebridge Investments in London.
Both from fundamental and technical viewpoints, the euro could be headed for another leg of weakness, he said. “It’s still vulnerable.
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