Euro Exchange Rate to Suffer as ECB Tipped to Stoke the Carry Trade at March 10 Meeting

The shared currency could lose ground against higher yielders as a result of ECB policy moves which could increase its attractiveness as carry-funder.

It has been suggested the European Central Bank (ECB) is likely to decerease demand for the euro at its March 10th meeting.

We are told that the euro is likely to be left particulatly vulnerable to higher-yielding currencies such as the Australian and New Zealand dollars as policy moves are tipped to fuel the carry trade.

ECB official, Benoit Coeure’s assertion that the governing council would be keeping a close eye on the impact of their policies on banks led to a 4.0% rally in the the Eurostoxx Banks Index on Tuesday.

It had been feared the ECB would cut interest rates even deeper into negative territory at their March 10 meeting – possibly even as low as -0.5% - after inflation data disappointed in December.

Negative rates mean banks are charged to deposit money with the ECB, currently at -0.3%.

Banks have complained, however, that these charges – which are estimated to have mounted to 1.2bn since thir inception (June 2014)– are hitting profitability to such an extend that they are limiting bank-lending to the wider economy.

This is completely counter-intuitive as it is increased lending that the ECB is ultimately trying to achieve.

ECB to Stoke Carry Trade Demand

According to ING Bank’s Christopher Turner the possibility the ECB may soften the blow on banks has increased its attractiveness as a funding currency for the 'carry trade':

“The Eurostoxx Banks Index enjoyed a 4% rally yesterday after ECB’s Coeure hinted that the ECB was assessing the impact on banks ahead of a policy move next week. As we noted yesterday, that supports EUR-funded carry strategies – as least as long as US wages do not surge in the NFP report tomorrow and question whether the Fed is behind the curve.”

The 'carry trade' is where investors borrow money at low interest rates and invest it where interest rates are higher. An example would to be borrow euros and transfer the money into a South African rand savings account where you could earn higher interest.

Vast sums of money move around the globe chasing higher yield, and we can immediately understand why it would push down the value of the funding currency, in this case the euro.

Impact on the Euro Exchange Rate

ING forecast the euro to dollar exchange rate to continue trading within a range of between 1.0800 and 1.0900.

More notable losses are however likely against the higher yielders targetted by carry traders in their strategies, including AUD, NZD, ZAR to name but a few.

The stabilisation in global uncertainty and the infant recovery in commodities may only accelerate the move as investors will likely borrow cheap euros to fund punts on global markets. 

This helps explain why the euro rises in times of stock market selling when traders unwind their euro-funded bets leading to a sudden surge in euro buying as the currency is 'sent home.'

ING's Turner first raised the point in his piece on the euro on Tuesday March 2 when he argued the RBA’s move to reduce its euro reserves and replace them with Korean Won instead, “serves as a reminder of the vast swathes of negative rates across the Eurozone – especially since the RBA has a very short duration in its FX reserve mix of just 6 months.”

Turner adds that the ECB may use “larger exemptions on negative rates” to soften the blow for banks, which means that they may allow them a larger reserve buffer before the negative rates kick in.

The current minimum reserve amount is 1.0%.

“We doubt he’ll (Benoit Coeure) will reveal details of what the ECB plans next week.but we are erring to a move which will depress rates, but not depress bank stocks (e.g. larger exemptions on negative rates). This would favour a continuation in EUR funded carry trades. EUR/USD looks to trade 1.0800-1.0900. For those brave enough, EUR/TRY could edge a little lower – perhaps to the 3.1500 area,” says Turner.

Sceptical Over ECB Effectiveness

Societe Generale’s Alvin Tan meanwhile tells us he is sceptical about whether the ECB will be sufficiently aggressive to push down the exchange rate, remarking that:

“News about ECB deliberations ahead of the policy meeting next week indicate growing concern about pushing rates further into negative territory.

"The focus might be shifting to asset purchases and implementing a tiered deposit rate on excess reserves. This could just be trying to rearrange the deck chairs, as the impact of unconventional policies fade. Consider that the trade-weighted euro exchange rate has broadly traded sideways since the ECB launched large-scale asset purchases in late January 2015.”

UBS think the ECB will likely decide to include corporate bonds in its asset purchases, but not bank bonds.

"We expect the ECB to increase its monthly asset purchases by at least €10bn (from €60bn currently) on 10 March and cut the deposit rate by 10bps from -0.3% currently, probably with a tiered structure," says UBS economist Reinhard Cluse.

"We expect the ECB to keep some of its powder dry, and reconsider the end of its QE programme (currently March 2017) and tapering at a later stage," says Cluse.

Recent Data Improving

The euro was supported by recent data which showed the Composite PMI in February rising to 53.0, and surprising analysts who had expected it to flat line at only 52.7.

Retail Sales in the region further boosted the currency after rising by a stonking 0.4% mom, easily beating the 0.1% expected; December’s figure was revised up to 0.6%.

Year-on-year sales rose by a higher-than-expected 2.0% when only 1.3% had been forecast. It too was revised up in the previous period to 2.1%.