FX Daily: Calls for the Euro as a funding currency are extremely premature

10th June 2014

  • The latest Manpower quarterly employment outlook shows recruitment levels in the UK have risen to levels last seen before the GFC. (The Times)
  • ECB President Draghi is expected to meet with Greece’s main opposition SYRIZA party leader, Tspiras in Frankfurt Tuesday and is expected to discuss the upcoming negotiations for a second debt relief deal as well as a possible third loan. (MNI Market News)
  • The latest MOF investor flow data shows Japan has renewed its interest in Australia. April saw net inflows from Japanese investors total some $2.7bn in sharp contrast to 2013 when pronounced easing from the RBA and a stellar rally in Japanese equities, saw Japanese investors sell some $35bn of Australia assets. (The FT)
  • For the first time in over 44 year, overseas tourists spent more money in Japan than Japanese tourists did abroad. A weakening yen was also behind the “tourism surplus” with the revenue from tourism providing another avenue of growth for the Japanese economy. (The FT)
  • The PBoC will continue to use a variety of policy instruments to adjust interbank market liquidity. The bank will work on improving the credit structure and deepening financial reforms to ease financing problems, including the issue of high borrowing costs. (People’s Daily)
  • The second targeted reserve cut is expected to release CNY50 –CNY100 billion in funds into the market. The move effectively rules out a system-wide reserve cut, as the central bank has added funds via other measures as well. (Sina.com)
  • China’s May CPI rose to 2.5%, from 1.8% previous and beating expectations of 2.4%. The increase was based on a rise in pork prices and base effects.
  • Australia NAB Business Confidence remained unchanged at 7 in May despite a decline in Business Conditions to -1 from 0.
  • Australia April Home Loans were flat on the month, despite forecasts for a 0.2% rise and following an upgraded -0.8% contraction.
  • Australia May ANZ Job Advertisements fell -5.6% on the month, with May downgraded to a 1.9% rise from 2.2%.

The euro took a substantial knock lower yesterday, persistently sliding from $1.3669 to below the $1.36 level across the European session. The move was sparked by an article in the FT suggesting lower Eurozone interest rates meant the euro would be used as a funding currency as the carry trade made a comeback. In fact the euro’s biggest slide yesterday was against the three main carry currencies – New Zealand dollar, Aussie dollar and the loonie. Eurozone money markets have fallen lower since the ECB’s announcement last Thursday providing some support to the euro funding currency argument. Eonia had its lowest fixed on record this morning at just 0.067% and the Eurozone Libor rate is tracking lower with general money market spreads compressing. However peripheral yields sunk even further yesterday with the Spanish 10 year yield below the US Treasury equivalent stealing most of the headlines. While the exuberance in peripheral debt is one thing, overall Eurozone debt has seen incredible demand. The Germany 10 year is at just 1.379%, and has been consistently below the US yield since 2011. What is the incentive for investment managers of holding German debt over US Treasuries? Bond market moves yesterday showed that there is incredible demand for Eurozone assets and that peripheral bonds markets don’t look set to lose out to the traditional high yielding class any time soon. One reason is that bond markets are still betting on ECB QE. Stopping the sterilisation of SMP purchases was effectively the ECB dipping its toe in outright asset purcahses and removing some of the stigma attached. Another reason could be that bond markets believe banks will use TLTRO to buy govvies anyway as conditionality isn’t that stringent. Or sometime the simplest answer is the right one – investors want exposure to the Eurozone. Not on expectations for a stellar recovery but simply on the belief that the economies will return to trend growth.

We have to raise an eyebrow at the recommendation of carry trades after the sharp sell-off that happened last year. Have market participants already forgotten that the prospect of reduced global liquidity brought to light the fundamental weaknesses in some of these economies? Their flaws and the Fed’s desire to scale back its balance sheet haven’t gone away, but apparently investors are just that dangerously complacent. Currency investment managers haven’t fully gone back into the carry trade since the 2008 crisis when carry strategies blew up. In the Great Moderation that preceded the 2008 crisis, currency investors performed carry strategies funded mainly through the yen, but the equities sell-off and increased volatility in 2008 meant these trades quickly soured. With increased scepticism over the current record low volatility, now does not seem like the opportune time to get back into the carry trade.

The Australian dollar is perhaps a good example this morning. Australian jobs adds dropped -5.6% in the month of April coinciding with falls in business and consumer confidence following the Treasury austerity budget. There was further news that the Australia housing market is cooling and the economy is about to lose a key support. Home loans were flat on the month and preliminary data from RP Data showed house prices in 5 key cities fell 0.2% in the week, taking the month on month fall to 2.0%. Aussie dollar continues to trade within a tight $0.92-$0.94 range supported by demand for triple A carry but dragged down by domestic fundamental weakness. We see the Aussie largely range bound over the summer months. However the Aussie will struggle into the second half of 2014 as the ECB fails to announce QE and the Fed moves closer to tightening. Ebbing level of global liquidity will uncover the underlying weakness in these currencies once again.